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OPEC Demand Drives Oil-Price Surge

Soaring demand within OPEC countries undermines the production hike.
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This time, OPEC really is to blame for higher oil prices.

In recent days, oil traders and speculators have forced the price of oil above $80 a barrel despite the Organization of Petroleum Exporting Countries' decision to raise production.

I fully expect oil prices to keep rising for the rest of 2007 and into 2008. The only thing likely to stop oil from climbing to $85 a barrel is profit-taking by speculators themselves.

Not every OPEC country is happy about this rise in oil prices. The Saudis, for example, have argued for increased production to hold down prices and keep demand from falling. But oil prices are headed up no matter what OPEC says or does.

And OPEC really doesn't have anyone else to blame for its inability to set prices. Runaway demand in the oil-producing countries themselves is the newest factor pushing up global oil prices.

A Speculator's Market

You can see where oil prices are headed in the reaction on Sept. 12 to OPEC's announcement that it would increase production. Despite the news, prices went up that day. The price of a barrel of benchmark West Texas Intermediate crude climbed $1.68 to $79.91.

The next day, crude tacked on an additional 13 cents a barrel to close at $80.04. Speculators were ecstatic: Hedge funds and other traders have staked out big positions in the options market at $80 a barrel that are worth billions as oil climbs above that level.

So why were traders able to move oil prices up in the face of an OPEC production increase?

  • A 500,000-barrel-a-day increase in production is little more than symbolic. If the Saudis, the driving force behind this increase, were serious about holding prices at this level or driving them down, they would have pushed through an increase of 1 million barrels or more. All an increase of this size does is ratify current levels of production, which are as much as 2 million barrels a day above the official quota.
  • There's a huge debate inside the oil industry and in the commodity pits about the status of Saudi oil reserves. The Saudis, who produce 9.5 million barrels a day now, have announced they will boost production to 12.5 million barrels, a 32% increase, by the end of this decade and to 15 million barrels by the end of the next decade. However, some oil traders and industry analysts don't believe Saudi Arabia can deliver, and they contend that the Saudis' big oil reserves are in far worse condition than the Saudis are letting on. The impact of any shortfall would be huge, because the Saudis are the only likely global source of a major increase in oil production in the next five years, according to the International Energy Agency. Without that production increase, the world is headed for a very painful short-term oil squeeze, the agency has concluded. So you can think of energy traders' bets on oil climbing above $80 as a huge vote that the Saudis won't or can't deliver as promised.
  • Traders and analysts also aren't convinced that OPEC as a whole wants to increase production. The Saudis carry great clout inside that organization, but they have faced fierce opposition this year from an OPEC faction headed by Venezuela and Iran that is adamant about keeping prices as high as possible. Both countries desperately need high oil prices: Oil revenue is the only thing that stands between the regimes that rule in Caracas and Tehran and huge, possibly uncontainable protests. Anything that cuts into revenue, endangering subsidies that keep gasoline prices in Iran near 40 cents a gallon and that fund cheap food and health care in Venezuela, would be a political disaster.

In the past, Venezuela and Iran probably wouldn't have carried the day. OPEC regularly raised production to modulate price spikes, so that peak oil prices wouldn't cut into global economic growth, leading to lower demand for oil and a plunge in oil prices.

In other words, OPEC felt it was in its own interest to avoid pushing the global economy into a slowdown with unsustainably high oil prices. Sometimes OPEC got it wrong and set prices too high or moved too slowly to lower them, but heading off an economic slowdown has been a fundamental part of OPEC policy.

Demand Stays High

But recently, higher global oil prices haven't reduced global demand for oil or pushed economies into recession. In its Sept. 12 projections, the International Energy Agency cut its estimate of global oil demand for the end of 2007 to 85.9 million barrels a day, but that is still 1.7% higher than demand in 2006. For 2008, the agency is projecting a 2.4% increase in demand.

You already know part of the reason for that. The developed economies of the world have become a lot less energy-intensive over the past three decades. For example, in the U.S., energy use per unit of economic production (gross domestic product) fell by 28% from the OPEC oil embargo of 1973 through 1995.

Higher oil prices were responsible for much of that decrease in energy use. From 1995 through 2004, energy use per unit of the economy fell an additional 26%. This time the decline had less to do with energy prices, which plunged at the beginning of that period, than with the steady shift of the U.S. economy from manufacturing to service industries. The same trend shows up in Europe and Japan.

Because these economies use so much less energy per unit of GDP than they did 30 years ago, they're a lot less sensitive to increases in energy prices. Energy is simply a smaller part of the cost of doing business in these economies for most companies.

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Emerging Consumption

The other part of the story that you probably know involves the developing economies of China, India and the rest of the rapidly industrializing world. Between 2000 and 2006, when global oil demand grew by 8 million barrels a day, growth from China alone accounted for about 32% of the total increase, according to the International Energy Agency. (The U.S. accounted for 12.5% of growth.)

Energy use in these developing economies has also been relatively insensitive to rising oil prices. Some developing economies -- China is the most important example -- are mixes of command-style and free-market economies where the government sets prices and determines profit goals.

Also, these economies are showing their own improvements in energy efficiency, and, most important, when an economy is growing at 11% a year, breakneck revenue growth overwhelms concerns that higher energy costs might cut into profit margins. Total profit is growing so fast that nobody worries much if margins are falling.

OPEC's In-House Demand

But there's a third part of the global energy demand story that hasn't received much attention until lately -- and it explains why higher oil prices haven't slowed global economic growth more rapidly and why OPEC is getting badly beaten by the energy traders these days.

Remember that I said that China had accounted for 32% of global growth in oil demand from 2000 to 2006 and that the U.S. had accounted for 12.5%? Well, there's another group of countries that, when it comes to global growth in oil demand, has been more important than the U.S. and only slightly less important than China. From 2000 through 2006, OPEC countries themselves accounted for 22% of global growth in oil demand.

In these OPEC countries, because oil consumption is so heavily subsidized, either directly in the consumer market or through government subsidies to energy-intensive industries, the rising market price of oil isn't felt much at all. Though higher market prices for oil are putting pressure on government budgets in these countries -- those subsidies cost money -- they have almost no effect on energy consumption.

From 2000 through 2006, oil consumption by OPEC countries climbed by 1.8 million barrels a day, or 29%. Consumption is projected to climb 400,000 barrels a day more this year. OPEC consumption has been growing at 2.5 times the rate of global consumption.

By the end of this year, consumption growth in OPEC countries will just about wipe out all the 2.2 billion barrels a day in increased production that OPEC has added since 2000.

Expect More of the Same

Traders are right to assume that this trend isn't about to reverse anytime soon. Saudi Arabia and Iran are determined to use their oil riches to build energy-intensive economies. Venezuela, Mexico and Iran use higher oil revenue to fund their governments and to subsidize prices for everything from gasoline to pharmaceuticals to food. Young and increasingly well-off populations in these countries want the energy-consuming trappings of wealth that are already enjoyed in the developed countries.

And because subsidized domestic market prices for oil and gasoline are so low in OPEC countries, there's little incentive for improving energy efficiency or switching to other fuels.

As oil prices go up, the economies of the OPEC countries boom. That increases consumption in OPEC countries, which drives up oil prices and stretches out the economic boom. Which drives up consumption. Which sends oil prices up again.I don't know whether you want to call this a vicious or a virtuous cycle, but a cycle it is, and it is clearly pointing to higher oil prices unless the Saudis can pull a couple of million barrels of production a day out of their hats.

The oil speculators have made a pretty good bet.

Jim Jubak is senior markets editor for MSN Money. He is a former senior financial editor at Worth magazine and editor of Venture magazine. Jubak was a Bagehot Business Journalism Fellow at Columbia University and has written two books: "The Worth Guide to Electronic Investing" and "In the Image of the Brain: Breaking the Barrier Between the Human Mind and Intelligent Machines." As an investor, he says he believes the conventional wisdom is always wrong -- but that he will nonetheless go with the herd if he believes there's a profit to be made. He lives in New York. While Jubak cannot provide personalized investment advice or recommendations, he appreciates your feedback;

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