Text of speech given by Sheikh Ahmad Zaki Yamani

Feb 04, 2002 01:00 AM

This is the text of the speech given by Sheikh Ahmad Zaki Yamani, Chairman of the Centre for Global Energy Studies and former Saudi Minister of Petroleum, at the CERI World Oil Conference, held in Calgary, Canada on 28-29 January 2002.

Oil producers outside OPEC were concerned recently that OPEC might be entering a phase in which it wishes to defend its market share rather than the oil price. The Organization's latest output cut had prompted such concerns, for it was made conditional on key non-OPEC producers delivering production cuts of their own. Whether or not Russia, Mexico, Norway, Oman and Angola deliver genuine cuts only time will tell, while OPEC's true market share intentions remain a subject of considerable interest.

The first point to make is that if OPEC really wanted to hold on to -- if not increase -- its market share, then the non-OPEC upstream sector of the oil industry would have cause for serious concern. After all, in a straightforward economic fight for market share thoseproducers with the lowest cost would always win and few would dispute that OPEC's membership includes some of the lowest-cost oil producers in the world.
However, having low costs is not enough; an increase in market share also requires spare production capacity, but OPEC has that too -- and in abundance. In December 2001, OPEC's excess production capacity amounted to almost 6 mm bpd (8 % of global oil demand), 50 % of which belonged to Saudi Arabia, whereas the non-OPEC producers have no spare capacity whatsoever.
For a group of producers to gain market share in a stagnant market they must be prepared to accept a price decline, which could end up being very steep indeed. If the group's percentage volume gains do not outweigh the percentage drop in the price, the group will invariably lose revenue. In such circumstances, the question is whether OPEC would be willing to accept the inevitable losses in revenue that would accompany its push for higher market share.

OPEC, in fact, is not a monolithic organization but a collection of member-states with varying interests and, therefore, disparate objectives. Some members like Algeria, Qatar and Indonesia are relatively small oil producers with not much scope to increase their output; they generally prefer higher oil prices to greater market share.
Others, like Saudi Arabia, the United Arab Emirates and Kuwait, have abundant oil reserves and should -- logically speaking -- always be interested in defending their market share; yet at times like the present they favour higher prices. Others, like Iran and Iraq, want both higher prices and greater market shares.
What will actually happen in 2002 depends largely on Saudi Arabia, the leading country within OPEC. At present, the Kingdom seems to be keen on defending the price of oil because it has budgetary problems. According to work undertaken by the CGES, Saudi Arabia needs a price of around $ 20/bbl to meet its rather modest $ 31 bn oil revenue target for 2002 with oil production at its new quota levelof 7.05 mm bpd.

The Kingdom could, of course, reduce its output further so as to raise oil prices higher still; however, there are both theoretical and practical limits to its ability to reduce production. In 1979, when Saudi Arabia's oil production (including NGLs) was at an all-time peak, its share of world demand stood at 19 %, whereas now it is at 10 %. For a country with 25 % of the world's proven oil reserves to meet only 10 % of global demand means that it is under-utilizing its oil reserve base.
On a practical level, Saudi domestic oil consumption is around 1.3 mm bpd (including 0.2 mm bpd of crude oil burnt directly without being refined), while crude oil exports earmarked for barter purposes and special projects are about 0.9 mm bpd. This leaves the Kingdom with a relatively modest 4.8 mm bpd for crude oil exports when its output is at 7 mm bpd.
Saudi Arabia also needs to keep its output at a certain minimum level because it depends on the associated gas from oil production to run some ofits power-generation and desalination plants. This minimum level cannot be known precisely, but it is probably not much less than 7 mm bpd. The other consideration to bear in mind is the wishes of the United States regarding oil prices. In 1986, when Saudi Arabia was willing to go all out for a greater market share, the US made it quite clear that this policy was far too damaging to the US' interests and would have to be modified.

Although Saudi Arabia is unlikely at present to wish to lead OPEC into a tussle for a larger market share, one should at least consider the possibility that OPEC may decide sometime in the future to improve its share of the oil market. If this were to happen, how could OPEC prevent an inventory build-up that would lead to prolonged price weakness?
As mentioned already, if OPEC really wanted to defend its market share in a weak market there is little it could do to prevent the price of oil from falling heavily. What happens to prices under such conditions depends to a large extent on the oil companies' level of desired inventories, which in turn depends on oil price expectations.
If the market is in contango, with futures prices above spot, there is a clear economic incentive to put oil into storage, provided working capital costs and storage expenses are covered. Buying oil for storage and simultaneously selling it on the futures exchange when futures prices are above spot enables the operator to lock in a suitable gain over and above costs.

Indeed, one could argue that in these circumstances spot oil prices have to fall sufficiently in relation to futures prices in order to give companies enough incentive to buy and store this 'unwanted' oil. OPEC's action in defending its market share, therefore, implies a tacit acceptance of a price fall and a commensurate inventory build-up. Strategic oil stocks, on the other hand, are different for they are held by governments and are not subject to commercial pressures.
If OPEC were to decide to enhance its market share in the interests of controlling the oil market, is there a particular level it would -- or perhaps should -- aim for? OPEC's market share (including NGLs) in the first quarter of 2002 is expected to be around 33 %, assuming that its member-countries comply only partially (60 %) with OPEC's latest 1.5 mm bpd cut. This share, it should be noted, is much lower than the Organization's 39.2 % average market share over the whole period 1990-2001, a period during which the OPEC basket price reached a high of $ 27.6/bbl (2000) and a low of $ 12.3/bbl (1998), yielding a period average of $ 19/bbl.
During the years 1995 and 1996, when the oil price was close to the period average of $ 19/bbl, OPEC's market share was around 39 %; the same correlation is observed during the years 1991 and 1992. However, not too much should be inferred from this, because in the year 2000 OPEC's market share stood at 40.3 % and yet the oil price was almost 50 % higher than in 1997 when its share was almost identical. Recent history, therefore, leads one to conclude that there is no particular level of OPEC's market share that allows it to control prices.

One can go further and say that OPEC does not seem to target a particular market share. Instead, it appears to have a target price in mind and to adjust its production in order to try to attain this target.
OPEC's official target price range is $ 22-$ 28/bbl for the OPEC basket, but it has been suspended for the time being, the Organization says, because of the weak global economy. Some have interpreted this suspension, in conjunction with the conditional nature of OPEC's latest cut, as an indication of OPEC's underlying desire to defend -- if not boost -- its market share. For my part, I am convinced that although OPEC has indeed formally set its target range to one side, its leading member-countries do not want the basket price to drop below the floor of the price band.

Analysis by the CGES suggests that Venezuela needs a minimum price of $ 21/bbl in 2002 merely to keep its fiscal deficit at the budgeted level of $ 6.1 bn. Iran, too, requires a price of around $ 21/bbl this year, otherwise it will have to draw on its stabilization fund, or reduce government expenditure, or restrict private sector imports, or borrow externally, or pursue some combination of all these essentially undesirable options.
Saudi Arabia is budgeting for a large fiscal deficit of $ 12 bn in 2002 and, at its new quota level of 7.05 mm bpd for the first half of this year, requires a minimum price of $ 20/bbl to reach its targeted oil revenue figure. Oil prices much below $ 20/bbl in 2002 would therefore cause these three key OPEC countries to experience acute financial pain and perhaps lead to serious political difficulties for Venezuela.

For OPEC to force oil prices below $ 20/bbl -- despite the obvious short-term financial pain -- would make sense if the intention is to render some non-OPEC production uneconomic and thereby boost OPEC's market share. However, as the oil price falls below $ 20/bbl there is hardly any non-OPEC output that would be shut in on economic grounds (i.e., because operating costs are not covered). For this to happen the price would need to drop below the $ 15/bbl level.
Around 0.3 mm bpd of US stripper-well production is vulnerable below $ 15/bbl and some Albertan tar sand production and Californian heavy oil output would suffer below $ 9/bbl, but that is about the extent of the potential damage to non-OPEC production in the short term. This suggests that OPEC's dash for market sharer would be doomed to failure unless the Organization was prepared to endure sharp falls in its oil revenues.

The Canadian tar sands are a case in point. It is my understanding that the operating cost of producing bitumen from these tar sands is around $ 8/bbl; to this must be added around $ 4/bbl for capital costs. Shell's Muskeg River scheme (0.155 mm bpd at a total development cost of $ 3.1 bn) is said to yield a rate of return of 12 % with WTI prices at $ 12/bbl.
In view of OPEC's needto keep the basket price above $ 20/bbl in 2002, it is easy to surmise that Canada's oil sands will be safe from any OPEC threat this year. However, is OPEC itself safe from these oil sands? Dr Lukman -- the President of Nigeria's special oil advisor and the new president of OPEC -- thinks OPEC does not have much to fear, but there are some who predict that these oil sands projects will displace up to 80 % of the US' current oil imports from the Middle East.
The US imports at present around 2.75 mm bpd (24 %) of its oil from the Middle East. To displace 80 % of this oil requires 2.2 mm bpd, which is a sizeable volume of oil indeed. Tar sand production in Alberta is expected to double by 2007, reaching 1.2 mm bpd. It is thus doubtful whether Canadian tar sand production alone could displace 80 % of US imports from the Middle East. For this to happen one has to include Canada's heavy oil production, which is scheduled to rise to 1 mm bpd by 2005.

Heavy oil and tar sands from Canada could in principle displace 80 % of current US oil imports from the Middle East, but this could not happen before 2005-7. Nevertheless, it is fair to say that OPEC should worry about such developments, for they imply that the cost of alternative non-OPEC sources of oil like tar sands and heavy oils is not particularly high and that the volumes involved could prove significant in the longer term.
By its recent actions OPEC has shown that it wants certain non-OPEC producers to join its output cuts, but whether they will oblige is another matter. Personally, I doubt whether the five non-OPEC producers will deliver their pledged cuts of 0.46 mm bpd. Mexico will probably contribute a maximum of 30,000 bpd (against a pledge of 100,000 bpd) and Russia a token amount -- perhaps 20,000 bpd (against 150,000 bpd).

Russian producers Yukos and Sibneft desperately want to bring on-stream new production, which if they cannot export will weigh heavily on the domestic market and depress spot prices in Russia. Norway, for its part, may well play the same game as last time by delaying for a few months some of its planned new production for 2002. Angola and Oman are not expected to cut production at all.
I am afraid that this time around OPEC will have to go it alone with its production cuts if it wants to push the oil price back above $ 20/bbl. In this it should be successful, even with a rate of compliance that leaves much to be desired, since the oil market is tighter than many think. I myself believe there is a distinct possibility of an oil price rebound by the summer, which is precisely what most member-states in OPEC seem to want.
Yet this would be a pity, for it would threaten the incipient global economic recovery and lead to a recurrence of oil price weakness and another bout of output restraint. When oil prices sag due to a lack of demand, it makes little sense to attempt to push prices up again.
This policy would only weaken demand and bring prices down once more in a vicious circle.

Source: Middle East Economic Survey
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