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OPEC, Russia and Iraq

In September 1960, the Organization of the Petroleum Exporting Countries was born at a conference in Baghdad. Over the following 42 years it has managed to avoid serious retaliation for operating the most significant pricing cartel the world has ever known, as well as frequent threats to its unity resulting from internal differences and disputes.

However, over the next 12 to 24 months it faces one of the most critical, and potentially dangerous, periods in its existence. A combination of having sustained the average oil price at too high a level for too long coupled with the aftermath of a likely second Gulf war may have an explosive effect on OPEC.

The global oil industry has thrived due to OPEC interventions in the oil market, and the only reason why Russias economy still has a future is because of the supply reduction decision taken by OPEC in March 1999.

After several years of allowing uncontrolled supply growth among its members that brought the oil price down toward $10 per barrel, the decision to cut supply to just below demand and to continue cutting supply over the following three years forced a sharp price recovery, which led directly to both the recovery in the Russian economy and funded the growth in Russian oil production. This growth in oil production has certainly frustrated OPEC, but the war premium (currently about $8 per barrel) in the oil price over the past 12 months has prevented a more serious confrontation between OPEC and Russia.

Far from celebrating the fact that Russian oil companies are taking market share from OPEC countries, market participants and the Russian government should be praying for the survival of OPEC in order to avoid the supply free-for-all and price collapse that would be the inevitable legacy of its destruction.

Looking at the history of oil prices, there are several periods when the price has been sustained well above the average, and this has always been followed by a comparable period when the price has been below the average. The equation is relatively simple: High oil prices lead to increased competition, while encouraging substitution and conservation among consumers. This usually coincides with intensified internal squabbling among OPEC member states and an increase in quota cheating. And these factors historically have led to a fall in oil prices. Then the cycle starts again, almost irrespective of global demand.

Saudi Arabia tried to break this "boom-bust" cycle 20 years ago (when Sheikh Ahmed Zaki Yamani was oil minister and Faisal was king) in favor of a "fair" price negotiated with the United States but found no support from other members who, even today, dispute Saudi Arabias dominant role in OPEC. However, Saudi Arabia, with the largest quota share and over 50 percent of OPECs total spare capacity, plays a critical role in supply restraint, and without its willingness to be the "swing-producer," it is certain that all current OPEC countries will follow the example of non-OPEC producers and turn the taps full on.

The threat of a second Gulf war, and the political and economic consequences such a war could have for the Middle East and Gulf countries, mean that a lot more is at stake for OPEC than at any other time in its history. It may have to deal with accommodating a rehabilitated "post-Saddam" Iraq in OPECs quota structure. In addition, Saudi Arabias attitude toward the United States may have to change to ensure the survival of the ruling House of Saud.

Iraq is currently thought to be producing about 1.6 million barrels per day against a capacity of about 3 million barrels per day. Assuming there is no significant destruction of oil facilities, a post-Saddam Iraq can be expected to increase exports toward capacity, and OPEC countries would have no choice but to allow this.

Iraq has made no significant expenditures on its oil infrastructure since the start of its war against Iran in the 1980s. Many industry observers now assume that the current proven oil reserves of 113 billion barrels (last validated 20 years ago) will be increased to around 250 billion barrels once access is allowed for modern exploration techniques. Iraq should be able to increase daily production to 4.5 million barrels relatively quickly based on current proven reserves and eventually to over 10 million barrels if the higher reserve base is proven.

The only way that Iraq can increase oil exports to capacity without making the oil price collapse is if Saudi Arabia can persuade other OPEC members to agree to a pro rata reduction or, more likely, if it is willing to bear the brunt of the required reduction itself. Although Saudi Arabia doubled its daily output just after the first Gulf War, it will not be easy for it to reduce output significantly now due to internal budget constraints resulting from high defence, social and debt service costs.

The other important factor is the attitude of the United States. The United States is the largest oil importer in the world (importing about 12 million barrels of its 20 million barrel daily usage) and, as such, it could quite happily live with the disintegration of OPEC as a major beneficiary of the resulting supply free-for-all and price collapse.

This year, consumer countries will depend on OPEC supplies for 36.5 percent of total requirements. Within five years, assuming long-term average growth in demand, that dependency will rise to roughly 40 percent and within 10 years, to over 50 percent. Thus, it is easy to see why major consumer countries are getting more nervous about future supply dependency. If current trends continue, within 20 years the world will be completely dependent on OPEC and Russian/CIS oil. This is a compelling reason to neutralize the cartel before it becomes even more powerful.

Of course, the oil industry has a very powerful lobby in Washington, and cheaper oil is definitely not in its best long-term interest. What is in its best long-term interest is access to Iraqi reserves and a stable, predictable supply and price regime under a more compliant OPEC structure. Failing that, having control through a friendly regime of the probable 250 billion barrels of Iraqi oil reserves provides a very considerable cushion against the growing risk of regime change in Saudi Arabia.

The Russian economy is still in transition and still very dependent on oil despite the progress of the past three years. The economy should not be expected to move away from oil dependency in any meaningful way until there is a substantial increase in investments to sectors other than oil and gas. This is unlikely to happen until well into President Vladimir Putins (probable) second term in office, i.e. no earlier than in three to four years time. In the meantime, what happens to Iraq and OPEC is of critical importance to the Russian economy.

The ideal outcome for Russia is exactly the same as that for Saudi Arabia and OPEC, i.e. maintenance of the status quo and the sanctions regime on Iraqi oil. Thus, Russias opposition to a U.S. invasion of Iraq is completely rational.

It would be an irony indeed if events in Baghdad this winter were to signal the end of the modern oil era and OPEC, just as 42 years ago they saw its start.

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