Saturday, April 9, 2011

OPEC Needs Higher Oil Prices

The oil producers' cartel OPEC is making history.

For the first time ever, it will reap $1 trillion in export revenues if crude oil prices remain above $100 a barrel, according to the International Energy Agency. Talk about a gusher!

The IEA believes that Opec will hit that target as oil stays above $100 a barrel this year. It also added that the $1 trillion record will happen in 2011 thanks to both this high price and higher oil production.

This astounding figure again emphasizes the point that oil is the world's most important commodity.....

And its significance will only grow as developing nations, from China to India to Brazil, demand more energy.

Opec and Spare Capacity

The most immediate concern for markets is supply disruptions.

Libya was the world's 12th largest oil exporter, producing about 1.6 million barrels a day of high-quality crude oil. Saudi Arabia and other leading member of the cartel, including Kuwait and the United Arab Emirates, have rushed to offset the shortfall.

But as Saudi Arabia and others boost their production, Opec's spare capacity shrinks. It is now less than 4 million barrels a day.

This is well below the peak of 7 million barrels a day in 2009. However, it is still well above the 500,000 barrels a day of 2004 after Iraq went offline following the US invasion the year earlier.

Still, the cumulative effect of several disruptions in the Middle East could drain all the excess capacity.

The oil market is beginning to see this as a very real possibility as unrest spreads throughout the Middle East and North Africa. Although it must be mentioned that the stock market still seems to be blissfully unaware of such a no-longer-remote possibility.

For instance, there is great unrest currently occurring in Bahrain, Oman, Syria and Yemen. Yes, all of these countries are very small producers of oil. But collectively their oil production amounts to a not insignificant 1.5 million barrels of oil per day.

Even these small oil producers going offline would produce higher oil prices. Part of that reason is the fact that as Opec's spare capacity shrinks, the oil market will demand a bigger and bigger price premium. The premium will be to offset the risk that another big disruption, even a hurricane, will force the system to run at full capacity.

Opec Now Needs Higher Oil Prices

There is another reason higher oil prices are in our future. Governments in the region are set to adopt populist energy policies in order to quell political unrest.

The clearest evidence to date of this populism is the hand-outs and boost to public spending announced by King Abdullah of Saudi Arabia. The increased spending varies from one-off bonuses for public sector workers to the promise of half a million homes at affordable prices.

The policies, at a total cost of $129 billion, are equal to more than half the country's oil revenues last year!

Many veteran oil watchers believe the extra spending will lift Saudi Arabia's oil revenue needs on a percentage basis closer to those of Venezuela and Iran. Both countries are well known oil price 'hawks', always wanting much higher oil prices.

Saudi Arabia is likely to pay for this additional spending by tapping the country's reserves, worth an estimated $450 billion.

Even so, prices will need to average $83 a barrel this year for Saudi Arabia to balance its budget. Only a decade ago, the country achieved that with prices at only $20 a barrel.

Unfortunately for consumers of oil, the trend toward higher oil prices needed by the Saudi government will continue. According to the Institute of International Finance, by 2015 the Saudi government will only be able to balance its budget if oil prices are at $115 a barrel.

Saudi Arabia is not alone either in boosting spending among countries in the region. Other members of the six-nation Gulf Cooperation Council have been announcing similar policies. Kuwait, for example, has proclaimed a one-off bonus of $4000 for each citizen and promised free food staples for more than a year.

This higher social spending will not only put upward pressure on oil prices but will also reduce the funds available for state-owned oil companies to invest in adding future production capacity.

In addition, as governments in the region feel under threat from social unrest, they are extremely unlikely to make cuts in energy subsidies for the public. These subsidies have made fuel cheaper than water in many countries in the region.

These subsidies have led to runaway domestic growth in oil demand. This demand, over the past decade, has dented the region's ability to export oil.

For example, oil demand in Saudi Arabia has doubled over the past 15 years. This transformed the country into one of the world's top 10 consumers of oil.

If the trend continues – which is likely – Saudi Arabia and the Middle East at large will have less and less oil for export each year. Which means higher and higher oil prices for everyone else.

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