March 2, 1998
Crude oil prices are five dollars per barrel lower than last year with uncertain prospects for recovery. One of the keys to understanding any commodity is to gain a solid grasp of the fundamentals which effect changes in its price. Crude prices have dropped over $5.00 per barrel since last year. The simplest and the correct explanation for the decline is that supply exceeds demand. On the supply side, the details are in the politics of OPEC's continuing difficulties in policing its own quotas. On the demand side of the equation is the economic crisis in Asia.
Last December OPEC increased quotas from 25 million barrels per day to 27.5 million barrels per day for 1998. There is little doubt that on the day of the increase production already exceeded the new ceiling. A December EIA report on OPEC estimated the 1997 production of oil to be more than 10 percent above the new 1998 quotas for Venezuela, Nigeria and Qatar. On the other side of the coin, it also noted that due to limitations of production capacity Indonesia, Iran and Libya would not be able to meet their new quota. The real OPEC problem child is Venezuela with 3.25 million barrels of production per day and a current quota less than 2.6 million barrels.
As OPEC was increasing its production ceiling the crisis in East Asia was coming to a head. This is particularly important because increases in East Asian oil demand had been expected to approach 2 million barrels per day in 1998. During this decade East Asian energy demand increased 5.5 percent annually. That rate was over ten times the rate of growth in the rest of the world. Much of Asia now seems to be on the mend and OPEC has unintentionally come to the aid of the ailing Asian economies. The $5 per barrel drop in prices translates into net savings of 1.5 billion dollars per month for East Asia. The big winner of course is Japan with net imports of 5.8 million barrels per day.
The big oil news last week was an apparent solution to the crisis in Iraq and Indonesia's Mines and Energy Minister Ida Bagus Sujana's request that OPEC's Secretary General Rilwanu Lukman call for a meeting of OPEC ministers. It is not surprising that the call came from Indonesia. Indonesia cannot increase production and any increase in prices would be a boon for its economy.
As interesting as the current developments were meetings the previous week in Riyadh between Saudi Arabia's King Faud and Iran's former president Ali Akbar Hashemi Rafsanjani. There is a clear easing of tensions between Iran and Saudi Arabia. These two countries are the heavy hitters in the Persian Gulf and OPEC. Saudi Arabia produces 8.5 million barrels per day and Iran produces 3.6 million barrels per day. Rafsanjani would like OPEC to punish those who over produce. The problem is that, unlike the Texas Railroad Commission which until 1971 effectively controlled oil prices through production quotas (proration), OPEC doesn't have the Texas Rangers to enforce its rulings.
What happens next? Indonesia would like to have an OPEC meeting today, but the Saudis wanting to see some discipline on the part of other OPEC members will probably wait until March production numbers are available.
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Saudi Arabia could cut its production enough to increase prices to the point that even with lower production levels Saudi revenue would increase. However, the Saudi Kingdom found in the early 1980s that that policy only works in the short term. Other countries will still over produce at the expense of the Saudis.
East Asia could do much better than expected. Those prospects are better every day that oil prices remain low. As long as the level of OPEC discipline is as low as prices, an Asian recovery is probably the best prospect for price improvement. In any case, it looks as if any significant price recovery is at least several months in the future.
James L. Williams
WTRG Economics http://www.wtrg.com
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