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Under the Radar: OPEC's False Hope

While oil prices rallied on the news that OPEC will slash crude production by 1.5 million barrels per day (bpd) in January, the future and clout of the cartel has never been more in doubt.

The production cut, formalized at Friday's gathering of OPEC ministers in Cairo, took nearly two months to sell to its own members. That OPEC made the cut contingent on support from nonmembers, such as Norway, Russia and Mexico, further shows the growing helplessness of the cartel in controlling world energy prices.

"OPEC is desperate to secure output cuts from major non-OPEC producers because it does not want to lose market share if it cuts its own output in January," notes Leo Drollas of London's Centre for Global Energy Studies.

Friday's production cuts seem as slippery as oil.

Counting Barrels

OPEC members themselves are poor barrel counters when it comes to quotas. While OPEC claims to have cut 3.5 million bpd so far in 2001, that's on paper. Drollas estimates the actual reduction of the 10 OPEC members bound by the cartel has been closer to only 2.8 million bpd, putting compliance at 80% or less.

"Overproduction has risen as quotas have fallen," Drollas notes. "Unlike the past, when overproduction was limited to just a few of the Organization's members, it has become widespread during 2001. Even the big producers in the Middle East are well above quote, with Saudi Arabia overproducing by 170,000 bpd."

And that isn't likely to improve as the cartel implements new cuts next week. Tyler Dann, director of energy research at Banc of America Securities and a member of the TSC Energy Roundtable, says OPEC members will pay little attention to the new cuts. "We'd expect compliance with the new quotas to be weak," he says. "We expect real production cuts vs. November levels to be only 700,000-800,000 bpd from OPEC."

If correct, OPEC members will have ignored their own directive and, instead, simply come closer to fulfilling the previously announced reductions of 3.5 million bpd. "[We] are not convinced OPEC will be able to reduce actual output by more than 0.8-1 million bpd, doing in effect little more than implementing fully the existing output targets," notes Drollas.

Russian Bears

If OPEC can't count on its own members, promises from non-OPEC members such as Russia, Norway and Mexico are likely to be just as leaky. That's especially true given OPEC couldn't get the original pledge of a 500,000 bpd cut it sought.

While Russia agreed to cut 150,000 bpd for three months to appease OPEC, it isn't clear how such rhetoric will translate into action. History suggests it won't. In April 1999, Russia agreed with OPEC to reduce global oil production by about 7%. However, according to data from the International Energy Agency, Russia actually increased exports by 400,000 bpd.

And that was before Russia's new push to re-emerge as a global leader in energy markets. While OPEC has cut production this year, Russia has actually increased output by more than a half-million barrels per day. Plus, new exploration and production, as well as assistance from major integrated oil companies like BP Amoco (BP - Get Report) and Royal Dutch/Shell (RD), could well increase Russia's production capacity by 20% in the next three to five years.

Why would a country trying to reassert itself as a major global economic power agree to undercut that mission to assist a cartel that offers nothing in return? That's a good question, and one that suggests Russia will not be cajoled by short-term price supports that undercut its goal of becoming a major player in international energy markets.

"For Russia to demonstrate its commitment to the West, they can [live with] $15 oil," said Marvin Zonis, professor of international business at the University of Chicago Graduate School of Business, in a November interview.

That leaves countries like Norway and Mexico to shoulder the non-OPEC portion of production cuts. Both have hinted their cuts depend on cooperation from Russia and OPEC nations. If they see weak compliance on both parts, Norway and Mexico aren't likely to shoulder the burden alone, especially when such cuts would be meaningless to crude prices.

Banc of America's Dann predicts 300,000 to 400,000 bpd cuts from non-OPEC nations, putting compliance among noncartel members as low as 60%.

Drollas agrees. "The commitment from non-OPEC producers remains short of the 0.5 million bpd sought by OPEC, and even the pledges received so far are not certain to translate into actual reductions in supplies of oil to the market."


While additional production cuts are likely to have little short-term impact on energy markets, some pundits think OPEC's new cuts come too late in the game and actually may serve to destabilize energy markets later in 2002.

"OPEC does not need to cut to stabilize the market," notes Drollas. "With no further output cuts, [we] believe prices will stabilize around $18 per barrel for Brent in the first half of next year. ... This cut will be insufficient to meet OPEC's price target in the first half of 2002 and risks destabilizing the market in the second half of the year by slashing stockcover."

Indeed, sustained price support will come when demand re-emerges.

"The key issue remains demand, and oil markets are likely to remain soft until oil demand recovers along with the economy during the second half of 2002," Merrill Lynch energy analyst Steven Pfeifer told clients Friday.

If that happens and non-OPEC members don't follow rhetoric with action, OPEC will have effectively ceded market share just as demand is increasing, a clear victory for Russia and other noncartel producers at OPEC's expense.

Another unintended consequence of OPEC's stubbornness could be to jump-start President Bush's energy program, including domestic exploration in areas like Alaska. The cuts only highlight U.S. dependence on foreign energy sources, which typically re-energizes calls for conservation and increased domestic production.

For OPEC, the endgame isn't looking pretty.
Christopher S. Edmonds is president of Resource Dynamics, a private financial consulting firm based in Atlanta. At time of publication, neither Edmonds nor his firm held positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Edmonds cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send it to Chris Edmonds .

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