(Dr. Mehdi Asali)
There has been a widespread recognition, amongst analysts and observers of oil markets developments, that the upward trends of oil and commodities prices in the last several years (see table below); say 2003-2008; have been mainly due to a persistence excess demand for oil and other commodities over its sluggish supply. This demand driven increase of oil and commodity prices has been clearly influenced by outstanding economic performance of major developing countries particularly China and India and strengthened with an above the long-term trend economic expansion of OECD economies throughout this time period. World economy featured a robust real growth, averaging about 4.4-5.5 percent during 2003-07, associated with low inflation and low interest rate in most part of the world.
Commodities Price Indices, Annual Percent Change, 1973-2007
Source: IMF International Financial Statistics (2008)
This is reflected clearly in the interim report (July 2008) of an interagency task force (ITF) set up by the USA Commodity Futures Trading Commission (CFTC) “The world economy has expanded at its fastest pace in decades, and that strong growth has translated into substantial increase in the demand for oil, particularly from emerging market countries.
Figure 1. Oil Consumption Growth by Country 2003 to 2008
In the supply side, the production of oil has responded sluggishly, compounded by the production shortfall associated with geopolitical unrest in countries with large oil reserves. As it is very difficult to rely on substitutes for oil in the short term, very large price increases have occurred as the market balance supply and demand”. In the figure below world GDP and Oil production are depicted together in growth rate and the level to give a feeling of movements of these two important variables in the recent years: 
Figure 2. World GDP and Oil Production
Although expansion of economic activities continues in emerging countries, notably in China, India, Russia and Brazil, however, since mid 2007 there have been signs of inflationary pressures in developed and developing countries; and economic slowdown particularly in OECD. This disturbing trend in OECD since last year has raised concern about the future of the global economy. IMF reflects this concerns as follows “The global economy is in a tough spot, caught between sharply slowing demand in many advanced economies and rising inflation everywhere, notably in emerging and developing countries. Global growth is expected to decelerate significantly in the second half of 2008, before recovering gradually in 2009. At the same time, rising energy and commodity prices have boosted inflationary pressure, particularly in emerging and developing economies. Against this background, the top priority for policymakers is to head off rising inflationary pressure, while keeping sight of risks to growth” (World Economic Outlook Update July 2008).
Regarding the persistence growth of oil and other commodities’ prices (index) since 2003; some have argued that the current trend of high oil prices have been a key factor behind the emerging difficulties in the global economy and OPEC; as a major oil producing block of countries with a significant market power; is to blame for that matter. But this accusation cannot be justified and rejected by many commentators. Since the oil prices have been demand driven, higher oil prices has not been the main factor causing the recent economic slowdown in the North America, Japan and some members of the EU. Argus media in its weekly “Global Markets” issue of 18th August 2008 states this fact unambiguously “The trebling of oil prices since 2004 has so far failed to spark global recession. When oil prices trebled in 1979-80, the world slipped into a double dip recession. But the world has changed since then, as emerging markets have been driving the global economy in the new millennium”. Ayhan et al (2008) summarize these changes as follows: “The global economic landscape has shifted dramatically since the mid-1980s. First, there has been a rapid increase in trade and financial linkages across countries. Second, emerging market economies have increasingly become major players and they now account for about a quarter of world output and a major share of global growth”.
Consisting with these global changes, there have been significant changes with respect to consumption of oil and energy as well, particularly in OECD. Two distinct features of these developments concerned with the energy and oil efficiency and the share of energy and oil in average household expenditure. Higher oil efficiency could be better appreciated if we recall from IEA’s publication that oil intensity is now about 1/3 compared to what was in late 1970s and early 1980s. Also according to EIA, despite growing energy and oil prices in 2003-2007 the average share of oil and energy cost in US households still remain well below their level of early 1980s which was approaching to 9 and 4 percent respectively.
Figure 3. Oil Intensity and Per-capita Oil Consumption
Although many have rejected these accusations that OPEC is to blame for the current economic difficulties, however, with the appearance of inflationary pressures in both developing and developed countries since mid 2007 and growing signs of slowdown in OECD economies triggered by the housing sector crisis and financial contraction in the USA and some major OECD economies on one hand and surging of oil prices to a new and unprecedented heights of around $150 per barrel in July 2008 on the other, many have argued that in the circumstances continuation of the existing upward trend of oil and commodities prices could damage the global economy by deepening economic recession and fueling inflationary environment and one should not ignore the possibility of negative effect of relentless increasing of oil and commodity prices on global economy in the future. IMF in its update of the world economic outlook (July 2008) summarize this perception of inflationary pressures in the global economy “Inflation is mounting in both advanced and emerging economies, despite the global slowdown. In many countries, driving force behind higher inflation is higher food and fuel prices. Oil prices have risen substantially above previous record highs in real terms, driven by supply concerns in the context of limited spare capacity and its inelastic demand, while food prices have been boosted by poor weather condition on top of continued strong growth in demand (including bio-fuels).
OPEC shares this view that unreasonably high and volatile petroleum prices are harmful for the global economy and for that matter to both consumers and producers alike. However, it is important to put things straight to understand clearly the roots of recent economic difficulties so that OPEC is not seen causing problems, such as the global inflation, that it has not been responsible for. Krichene (2008) in his IMF working papers discuss the root cause of inflationary pressures and oil prices surges “..recent upsurge in oil prices were taking place in midst of rising trends in commodity prices, instability in housing, equity and credit markets and depreciating exchange rate. The fast rise in commodities prices including oil could be seen as delayed effect of excessively expansionary monetary policies during 2001-04 when key interest rate forced down to postwar record levels. Such monetary expansion led to high world economic growth and consequently higher world demand for oil and non-oil commodities.”
Unjustified high and volatile oil prices increases uncertainties concerning demand for oil and stimulates efforts to substitute other sources of energy for oil. Econometrics exercises indicates that a 15% increase in (average) annual oil prices in real term is capable of turning the rate of growth of demand for oil in OECD countries negative. This price threshold is about 70% for China with one period lag. IN other words a 70% increase in annual oil price would offset positive impact of the per capita GDP growth in China with one year delay. Therefore, OPEC opposes the unreasonably high oil prices; particularly when there are clear signs of economic slowdown in major OECD economies, as the largest oil consuming nations exacerbated by inflationary pressures in developing and developed economies alike. Higher oil prices could harm global economy and destruct demand for oil reducing oil exporting countries revenue in the long term. However, this would be naïve if one thinks that stability of oil markets could be restored and maintained by OPEC alone. Modern Oil and commodities markets where oil prices are now discovered and determined operate under influences of complex and heterogenous forces. This is now everyday observation that geopolitics, capital movements and open interest in paper oil markets, financial markets turmoil and the US dollar revaluations all exerts significant impacts on oil prices fluctuations. Although there have been no clear evidence yet of substantial impact through speculation in paper oil markets on average oil prices determined by the market forces, but impacts of these activities on volatilities of oil prices are less disputable.
In the circumstances when there are signs of weakening demand for the products and crude, unresolved obstacles in the downstream sector, increasing cost inflation of creating production capacity, etc. a significant increase in oil supply by OPEC, the action that the organization is called to undertake, could cause even greater instability in oil markets in years to come exerting heavy losses on revenue incurred by OPEC member countries and reducing investment on upstream activities of petroleum industry.
A volatile oil market also increases risks of investment on upstream activities and assuming its impacts on inflationary pressures this could even reduce profitability of oil production by cost inflation of exploration, development and production of petroleum. However, OPEC would strongly reject the unjustified accusations that the organization acts as a cartel and exercises its monopoly market power to keep oil prices at the highest level possible. Not only OPEC is not a monopolist in the oil market; with having only less than 40% share of global oil production, but also the organization cannot be considered a cartel because OPEC never hasn’t tried fixing prices and manipulating its market power to attain and maintain the highest possible oil prices. According to its constitution, OPEC is committed to oil market stability and tries to safeguard long term interests of its member countries taking consumers interests into consideration as well. In fact OPEC has increased its production more than 5 mb/d since 2003 (26.9 mb/d in 2003 to 32.1 mb/d in 2008) without which oil prices would have been much higher. The increasing volume of NGLs supplied by OPEC member countries to the global oil market, (now amounting to about 5 mb/d), is yet another example of OPEC member countries contribution to oil market stability in the recent years although this inevitable increase of OPEC’s share in the global oil market is dubbed as increasing reliance of the global economy on OPEC production by IEA and AEI.
Figure 4. Increasing Reliance on OPEC Production
Undertaking a growing share of the global oil production inevitably adduces the issue of production capacity of oil producing countries. This is a well known fact that world surplus production capacity is mainly concentrated in OPEC and its major oil producing countries particularly Saudi Arabia. Holding spare capacity by OPEC is an important part of its strategy to stabilize oil markets. Without significant surplus capacity there would be no buffer to offset supply disruptions and following a positive shock on global demand restoration balance in oil markets will be subject to significant price changes. However, maintaining spare capacity of a considerable size, say for example between 3.5 to 5.5 mb/d (corresponding to 4 to 6 percent of global consumption) is associated with substantial opportunity cost. For example holding surplus production capacity of 3.5 mb/d instead of producing and exporting this amount of crude could mean denying OPEC from about 3 to 4 percent of global oil sales revenue every year.
The growth rate of oil production in non-OPEC countries has been disappointingly low in the time period 2003-2008. This is one of the main reasons behind the tight oil market in the recent years. In fact non-OPEC production of oil has been fairly flat in this time period rising from 48.9 mb/d in 2003 to 50.0mb/d in 2008 with a mere 0.4% annual rate of growth. This means that not only demand for oil but also oil supply has been quite inelastic to price changes. While oil prices in real terms has increased more than 300% since 2003 non-OPEC oil production as a whole has remained almost the same implying a very low price elasticity of oil supply. Obviously not all the non-OPEC oil producing countries have had the same experience regarding expansion of their oil production capacity. While Russia, Azerbaijan and some other countries increased their production capacities, production declined in the North Sea, Mexico and the USA. However, net increase of non-OPEC oil production has been negligible causing increasing global reliance on OPEC crude. Even assuming adequate oil reserves in the world, raising production capacity in OPEC and non-OPEC countries will need huge amount of investment to meet the growing demand. H.E. El-Badri, OPEC’s Secretary General has pointed out recently that OPEC member countries are planning to spend $ 160 bn up to 2012 to increase capacity by 5m b/d. This accounts for more than $32,000 for creating one barrel per day of new production capacity. It goes without saying that for creating the same level of new production capacity non-OPEC countries will need to invest much more. This is in fact the technical basis of the OPEC market power in petroleum industry. Many economists believe that petroleum industry is an industry with increasing return to scale characteristics, meaning that for a considerable period of time average cost of producing crude oil could be diminishing. This is shown in different applied studies that, at least for large oil reservoirs, this is indeed the case. Since OPEC member countries of the Persian Gulf region are particularly known to be endowed with large oil reservoirs, one can expect that, given the current proven oil reserves and upstream activities technology, OPEC’s share of global oil production ought to increase.
Petroleum industry, particularly in upstream sector, is very capital intensive. An investment in upstream activities may take years to yield additional production capacity because exploration, development and production of crude are time consuming process. Also investment in oil sector is highly risky. This implies that for a long term investment for expansion of oil production in OPEC and non-OPEC countries, oil prices should remain stable and in a reasonable level to compensate for economic costs of development of new oil production capacity. All these refer to the fact that security of energy that is all important for the world economic well functioning require oil price to remain in a reasonable level in a range high enough to compensate for inflation cost and yield an attractive return of investment and at the same time lower than alternative fuels. Some supply analysts believe that this range is around $80 to $100 per barrel.
