Themes > Current Issues
25.03.2000
Once Again The OPEC Threat
C.P.
Chandrasekhar
Oil prices are once again the talking point in international economic
and financial circles. In the wake of the third agreement between members
of the Organisation of Petroleum Exporting Countries (OPEC) in March
1999 to cut production by 2.1 million barrels a day, oil prices have
risen sharply from less than $10 a barrel (in the case of OPEC crude)
to close to $25 a barrel. This agreement was the culmination of three
phases of withdrawing supplies from the market, starting in April 1998,
which had resulted in a sharp reduction in oil stocks worldwide. The
effects of OPEC's efforts were aggravated by Iraq's decision to exploit
the situation by stopping supply of 2.2 million barrels of oil a day
under the United Nations' food-for-oil programme, till such time as
sanctions were lifted. The consequent rise of oil prices to a nine-year
high set alarm bells ringing, with prognostications of a return to the
days of inflation and recession in the developed centres of the world
economy.
The dramatic turnaround in prices is remarkable because till a year back, developed (and developing) nations had wallowed in a world of low and falling oil prices. From a peak of close to $25 a barrel at the beginning of 1997, oil prices had fluctuated around a declining trend, taking the prices of OPEC crude to less than $10 a barrel over a two year period. That decline had triggered the argument that a "new paradigm" had come to characterise commodity prices in general and oil prices in particular, with the World Bank suggesting that there was "evidence of a fundamental break in the level of commodity prices, due to rapid advances in technology and declining costs of production". Though initially it was admitted that the crisis in East Asia had depressed oil demand and tilted the supply-demand balance in against oil producers, analysts soon argued that demand stemming from a buoyant US economy should have substantially neutralised that factor. More 'fundamental' factors were, therefore, seen as having worked on oil markets, to take oil prices to levels that were appropriate. Included among them, besides the technological trends mentioned earlier, was a perceived long-term tendency towards reduced oil dependence in the developed world. The world, it was held, had put the danger of spiralling oil prices behind it.
It has taken little to shake that complacence. OPEC countries, dependent on oil incomes for balance of payments stability and growth, could hardly accept the prices that prevailed in early 1999 as appropriate. Yet, even as national budgets were being squeezed and the threat of civil strife perceived, oil producers squabbled over quotas and production volumes. Eventually, the damaging consequences of the steep decline on countries dependent on oil exports forced a degree of unity and discipline among them, resulting in the March 1999 agreement. And when expectations that the agreement would not work were belied, the rapid price increase seen over the last year ensued.
There are now two questions being debated among oil analysts. First, can these prices be sustained or is the "new paradigm" in oil prices to be one of intense short-term volatility, which implies a downturn in prices some time in the near future? Second, what would be the macroeconomic implications of a regime of relatively high oil prices, for a world which is just seeing a halting recovery from the poor performance that marked the last years of the last decade?
An answer to the first is now quite clear. It emerges from the evidence that oil price volatility is more the result of supply rather than demand factors. The collapse in prices during 1997-98 was the result of the overhang in oil supply, resulting from the tendency of individual oil producers to try and grab a larger chunk of world markets in order to finance domestic expansion. It was the realisation of the futility of such a strategy, that helped restore unity and discipline within and outside OPEC. That unity helped ensure the production cuts that wiped out the supply overhang and triggered the price recovery.
There is a clear perception, however, that oil prices cannot keep rising. Its impact on inflation and the balance of payments in the developed and developing countries would trigger immediate and medium-term trends that are adverse from OPEC's point of view. Rising inflation and a widening current account deficit can necessitate contractionary polices in some or all countries which would impact on oil demand as well. Further, sustained high prices can rejuvenate the conservation effort which began with the oil shocks of the 1970s, but lost momentum during the years of low real and nominal oil prices. The deceleration and possible decline in demand that could result, would necessitate production cuts which may be unacceptable to many of OPEC's members.
It is for this reason that some OPEC members are making a case for increasing supply (to the tune of 1.2 to 1.7 million barrels a day) so as to bring prices down to the $18-21 range. Others, such as Venezuela, are reportedly arguing for even lower ceilings. Whether these moderates would be able to convince producers who want to make the best of the current situation to make up for past losses is yet unclear. But some effort to moderate the price level, even if not at levels as low as $18 seems a prerequisite to prevent oil price volatility.
There are many other dangers facing OPEC, however. First, there is the threat that lulled by the benefits of high prices, individual producers may be characterised by a loss of short-term memory. Forgetting the futility of breaking the cartel, they may make unacceptable quota demands and implement them in the face of disagreement, in an effort to use the current state of the market to quickly recoup the losses they suffered during 1997-98. This is a sure prescription for a sharp downturn in prices.
Second, the impact of high oil prices on consumers in the developed countries, has already set off frenetic efforts at oil diplomacy on the part of developed country governments, led as usual by the US. Annual inflation in the euro-zone hit the European Central Bank's target ceiling of 2 per cent in January for the first time since the euro's launch 14 months ago. The increase was mainly a result of higher energy prices. Producer prices in the US rose by 1 per cent in February, even though excluding energy and food, inflation stood at just 0.3 per cent. As expected, Republicans are making an issue of rising oil prices. Republican Senator Benjamin Gilman, chairman of the house international relations committee, has initiated discussions on legislation aimed at pressurising OPEC by stopping US aid and arms sales to countries seen to be engaged in oil price "fixing". This has forced President Clinton to promise "quiet diplomacy" to bring oil prices down and new measures to reduce America's dependence on oil imports. Given the differences in the relationships with and perceptions of the US among OPEC's members, the willingness to accommodate US demands may vary. The disagreement that ensues can once again threaten the cartel.
OPEC's real strength at the moment is the fact that even at the current high level of prices, the macroeconomic consequences in the developed world have not been too grave. While the actual and likely inflationary impact of the oil price increase has encouraged the US Federal reserve to raise interest rates marginally to moderate the persistently high growth rate in that country, no major contractionary response is as yet visible.
In the developing countries, however, the effects are bound to be severe. This would be true of even the more developed of the developing countries. Thus, during April-November 1999, imports of petroleum products into India rose by 5.1 per cent. But, the outlay on those imports rose by close to 60 per cent. This reflects the impact of an average price during that period of possibly around $18. For a full year, this would amount to an increase in foreign exchange outlay on petroleum, oil and lubricants of around $3.8 billion, which is well over a quarter of the trade deficit recorded in 1998-99. With the Indian government being in liberalising mode, unless the financing needed to meet that hike in the import bill comes in the form of capital flows, a degree of contraction may be inevitable.
Similar developments in East Asia may abort the recovery that promises to restore economic activity in these countries to levels that prevailed before the financial crises of 1997-98. OPEC decision-makers would need to factor this into their calculations of an appropriate price of oil, even from their own point of view. If not, even if these countries only account for a smaller share in world oil imports, a severe contraction could make a noticeable difference to world oil demand, endangering OPEC unity.
It would indeed be unfortunate if the unity forged in 1999 as a result of an unacceptable floor to oil prices is broken by an inability to agree on a ceiling to those prices. OPEC's effort in the 1970s to shift the international terms of exchange in favour of developing country primary producers and the rapid process of industrialisation in East Asia during the 1970s and 1980s constituted the two major post-war challenges to developed-country domination over the world economy. Both have faced setbacks since. The recent unity within OPEC and the dramatic effect it has had on oil prices promise to once again revive the struggle for a semblance of balance in the world economy. This opportunity must not be lost.
The dramatic turnaround in prices is remarkable because till a year back, developed (and developing) nations had wallowed in a world of low and falling oil prices. From a peak of close to $25 a barrel at the beginning of 1997, oil prices had fluctuated around a declining trend, taking the prices of OPEC crude to less than $10 a barrel over a two year period. That decline had triggered the argument that a "new paradigm" had come to characterise commodity prices in general and oil prices in particular, with the World Bank suggesting that there was "evidence of a fundamental break in the level of commodity prices, due to rapid advances in technology and declining costs of production". Though initially it was admitted that the crisis in East Asia had depressed oil demand and tilted the supply-demand balance in against oil producers, analysts soon argued that demand stemming from a buoyant US economy should have substantially neutralised that factor. More 'fundamental' factors were, therefore, seen as having worked on oil markets, to take oil prices to levels that were appropriate. Included among them, besides the technological trends mentioned earlier, was a perceived long-term tendency towards reduced oil dependence in the developed world. The world, it was held, had put the danger of spiralling oil prices behind it.
It has taken little to shake that complacence. OPEC countries, dependent on oil incomes for balance of payments stability and growth, could hardly accept the prices that prevailed in early 1999 as appropriate. Yet, even as national budgets were being squeezed and the threat of civil strife perceived, oil producers squabbled over quotas and production volumes. Eventually, the damaging consequences of the steep decline on countries dependent on oil exports forced a degree of unity and discipline among them, resulting in the March 1999 agreement. And when expectations that the agreement would not work were belied, the rapid price increase seen over the last year ensued.
There are now two questions being debated among oil analysts. First, can these prices be sustained or is the "new paradigm" in oil prices to be one of intense short-term volatility, which implies a downturn in prices some time in the near future? Second, what would be the macroeconomic implications of a regime of relatively high oil prices, for a world which is just seeing a halting recovery from the poor performance that marked the last years of the last decade?
An answer to the first is now quite clear. It emerges from the evidence that oil price volatility is more the result of supply rather than demand factors. The collapse in prices during 1997-98 was the result of the overhang in oil supply, resulting from the tendency of individual oil producers to try and grab a larger chunk of world markets in order to finance domestic expansion. It was the realisation of the futility of such a strategy, that helped restore unity and discipline within and outside OPEC. That unity helped ensure the production cuts that wiped out the supply overhang and triggered the price recovery.
There is a clear perception, however, that oil prices cannot keep rising. Its impact on inflation and the balance of payments in the developed and developing countries would trigger immediate and medium-term trends that are adverse from OPEC's point of view. Rising inflation and a widening current account deficit can necessitate contractionary polices in some or all countries which would impact on oil demand as well. Further, sustained high prices can rejuvenate the conservation effort which began with the oil shocks of the 1970s, but lost momentum during the years of low real and nominal oil prices. The deceleration and possible decline in demand that could result, would necessitate production cuts which may be unacceptable to many of OPEC's members.
It is for this reason that some OPEC members are making a case for increasing supply (to the tune of 1.2 to 1.7 million barrels a day) so as to bring prices down to the $18-21 range. Others, such as Venezuela, are reportedly arguing for even lower ceilings. Whether these moderates would be able to convince producers who want to make the best of the current situation to make up for past losses is yet unclear. But some effort to moderate the price level, even if not at levels as low as $18 seems a prerequisite to prevent oil price volatility.
There are many other dangers facing OPEC, however. First, there is the threat that lulled by the benefits of high prices, individual producers may be characterised by a loss of short-term memory. Forgetting the futility of breaking the cartel, they may make unacceptable quota demands and implement them in the face of disagreement, in an effort to use the current state of the market to quickly recoup the losses they suffered during 1997-98. This is a sure prescription for a sharp downturn in prices.
Second, the impact of high oil prices on consumers in the developed countries, has already set off frenetic efforts at oil diplomacy on the part of developed country governments, led as usual by the US. Annual inflation in the euro-zone hit the European Central Bank's target ceiling of 2 per cent in January for the first time since the euro's launch 14 months ago. The increase was mainly a result of higher energy prices. Producer prices in the US rose by 1 per cent in February, even though excluding energy and food, inflation stood at just 0.3 per cent. As expected, Republicans are making an issue of rising oil prices. Republican Senator Benjamin Gilman, chairman of the house international relations committee, has initiated discussions on legislation aimed at pressurising OPEC by stopping US aid and arms sales to countries seen to be engaged in oil price "fixing". This has forced President Clinton to promise "quiet diplomacy" to bring oil prices down and new measures to reduce America's dependence on oil imports. Given the differences in the relationships with and perceptions of the US among OPEC's members, the willingness to accommodate US demands may vary. The disagreement that ensues can once again threaten the cartel.
OPEC's real strength at the moment is the fact that even at the current high level of prices, the macroeconomic consequences in the developed world have not been too grave. While the actual and likely inflationary impact of the oil price increase has encouraged the US Federal reserve to raise interest rates marginally to moderate the persistently high growth rate in that country, no major contractionary response is as yet visible.
In the developing countries, however, the effects are bound to be severe. This would be true of even the more developed of the developing countries. Thus, during April-November 1999, imports of petroleum products into India rose by 5.1 per cent. But, the outlay on those imports rose by close to 60 per cent. This reflects the impact of an average price during that period of possibly around $18. For a full year, this would amount to an increase in foreign exchange outlay on petroleum, oil and lubricants of around $3.8 billion, which is well over a quarter of the trade deficit recorded in 1998-99. With the Indian government being in liberalising mode, unless the financing needed to meet that hike in the import bill comes in the form of capital flows, a degree of contraction may be inevitable.
Similar developments in East Asia may abort the recovery that promises to restore economic activity in these countries to levels that prevailed before the financial crises of 1997-98. OPEC decision-makers would need to factor this into their calculations of an appropriate price of oil, even from their own point of view. If not, even if these countries only account for a smaller share in world oil imports, a severe contraction could make a noticeable difference to world oil demand, endangering OPEC unity.
It would indeed be unfortunate if the unity forged in 1999 as a result of an unacceptable floor to oil prices is broken by an inability to agree on a ceiling to those prices. OPEC's effort in the 1970s to shift the international terms of exchange in favour of developing country primary producers and the rapid process of industrialisation in East Asia during the 1970s and 1980s constituted the two major post-war challenges to developed-country domination over the world economy. Both have faced setbacks since. The recent unity within OPEC and the dramatic effect it has had on oil prices promise to once again revive the struggle for a semblance of balance in the world economy. This opportunity must not be lost.
© MACROSCAN 2000