Does OPEC Have Sand in Its Eyes?

Controlling output to keep prices high may be a big mistake

On June 25, OPEC oil ministers will converge on Vienna for one of the increasingly frequent gatherings known as "extraordinary meetings." They will most likely agree to retain their current production ceiling, which nominally holds about 5 million barrels per day off the market. For the past three years, the OPEC countries' main goal has been keeping prices near their target of $25 per barrel. They have been successful: Crude trades at about $26 per barrel.

But instead of congratulating themselves on getting top dollar, the leaders of the major Middle Eastern oil producers, including Saudi Arabia, Kuwait, and Iran, should be asking themselves whether their focus on price makes sense for the long haul. The gulf states may have almost 65% of the world's reserves, but at the end of the day, it's not what you have in the ground that matters: It's what you pump and sell. In that regard, the petrol kingdoms run the risk of having their share squeezed by increasingly bold non-OPEC rivals.

At first glance, the idea that the Persian Gulf OPEC powers could lose their grip doesn't make sense. Conventional wisdom is that the gulf sits on a bottomless lake of oil that will always keep Saudi Arabia and its neighbors at the forefront of the industry. But a growing body of critics thinks that the gulf producers' focus on controlling prices and access to their fields jeopardizes the long-term health of their energy industries. "My great fear is that OPEC is getting more and more short-term," says Mehdi Varzi, president of Varzi Energy, a London investment firm.

Varzi and others believe the gulf states should start considering the consequences of their obsession with price. While bringing in high revenues now, prices of $25 or more will encourage greater investment in non-OPEC areas as well as new technologies, such as alternative fuels, that could make OPEC oil obsolete. At the same time, high prices depress growth and, as a result, demand for oil--especially in oil-thirsty economies like India and China. Fatih Birol, chief economist of the International Energy Agency in Paris, says that as a rule of thumb, a price of $25 per barrel over a six-month period will cut half a point off a developing country's GDP growth.

Thus Leo Drollas, deputy director at the Center for Global Energy Studies, a London think tank, forecasts that if prices of $25 a barrel are sustained through 2010, consumption will wind up being half what it would have been at $20 prices. In that gloomy scenario, OPEC would have no room to grow and might even have to cut output.

To create demand for its oil, OPEC should be gradually easing off the brakes. Of course, it would be impractical to ramp up production suddenly. But Drollas says that adding one million barrels per day would help strengthen the shaky world recovery by gradually bringing prices down to the $20 level that many observers think preferable for both OPEC and consumers. The gulf states would benefit, too. "Most OPEC countries need to expand production to achieve economic growth. But as OPEC members they can't," says Richard Gordon, executive vice president at John S. Herold, a Norwalk (Conn.) consultancy. That leaves the gulf regimes in a tight financial squeeze. With bloated welfare state to nourish, the political leaders of these countries are pressing for every riyal they can get--now. Drollas estimates the Saudis need average prices of $26.50 a barrel and production of 7.7 million barrels a day to afford 2002 budgetary expenditures of $59 billion.

Boosting output would also push the Saudis and other big producers to open their fields to outsiders. International oil executives say the industries in countries such as Kuwait and Iran, which have been isolated from the global industry, are decades out of date and badly in need of investment and technology. But oil in the Middle East remains so intensely political that changing the way it is managed is extremely difficult. Public opinion is against foreign participation, and the bureaucrats and political elite are reluctant to give up control over the main source of national revenue.

A case in point is Saudi Arabia's much-heralded initiative to lure international oil companies to invest in gas-related projects worth an estimated $25 billion. You would think that the Saudis, who desperately want jobs for a burgeoning, youthful population, would roll out the red carpet. To the contrary: ExxonMobil, Royal/Dutch Shell Group, and BP are said to be far apart from the Saudis on key issues: the quality of the exploration acreage the kingdom is willing to let the companies explore, for one, and also the returns they may gain on their investments. The companies want something in the high teens; the Saudis are said to think 10% is good enough. Once again, Lee R. Raymond and Phil B. Watts, the CEOs of ExxonMobil Corp. and Royal/Dutch Shell, are preparing to fly to Riyadh to try to break the deadlock.

Such situations have oil executives wondering why they bother with the gulf producers. "They are missing an opportunity because they are poor decision-makers and don't know how to move ahead," says one. No surprise, then, that the biggest oil outfits are turning to countries with far smaller reserves--but better deals that give investors choice acreage and a share of the oil produced. So BP (BP ), ExxonMobil (XOM ), and Shell are pouring billions into non-OPEC zones such as the Caspian basin, the Gulf of Mexico, and Angola.

Thus, non-OPEC crude increasingly competes with OPEC's production. OPEC's share of the world oil market has fallen, from 42% in 1999 and 2000 to about 39% for this year, according to PFCEnergy, a Washington consultant. In the coming years, OPEC may find itself even more pressured as large new non-OPEC projects like the Crazy Horse field in the Gulf of Mexico and Kashgan in the Caspian come onstream. Deutsche Bank forecasts that non-OPEC production in the coming decade will grow at twice the rate of the 1990s. "The big Middle East producers may well have missed the boat by letting investment go to Russia and the Caspian," says Edward L. Morse, senior analyst at Hess Energy Trading Co. in New York.

Even some officials in producer countries are beginning to doubt whether OPEC has devised a winning strategy. "We were all thinking that by 2010, our market share would get to 50%," says a senior gulf oil official. "That's going to be delayed." If pressures increase, analysts think countries such as Saudi Arabia might be tempted to break ranks, bring in outsiders to increase production, and realize their true potential by driving a stake through OPEC's heart. There is little sign now of such radical thinking. But by succeeding in the short term, OPEC may yet sow the seeds of its own demise.

By Stanley Reed in London

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