Oil prices: to the sky or stabilisation?

A speech by Dr Adnan Shihab-Eldin, Acting for the Secretary General to the Alfred Berg ABN AMRO's Nordic Energy Conference, Oslo, Norway, 30 August 2005

(Slide 1)
Excellency, ladies and gentlemen,

Let me begin by thanking the organisers for inviting me to address you on the subject of “Oil prices: to the sky or stabilisation?”, at the Alfred Berg ABN AMRO’s Nordic Energy Conference. The theme of the conference is “Energy flow in the North”.

My first reaction on seeing a title like “Oil prices: to the sky or stabilisation?” is to reemphasise OPEC’s commitment to stabilisation. After all, this is what OPEC sees as one of its principal objectives in the international oil market. OPEC’s very first Resolution, adopted at its formative Conference in Baghdad in September 1960, states that “Members shall study and formulate a system to ensure the stabilisation of prices.” This was revised slightly and formalised in the OPEC Statute during the following year, and since then has provided one of the main guiding principles for all our actions. (Slide 2) Article 2B of the Statute reads: “The Organization shall devise ways and means of ensuring the stabilisation of prices in international oil markets, with a view to eliminating harmful and unnecessary fluctuations.”

But there is more to it than that. What price levels are consistent — or compatible — with stabilisation? The time dimension also enters the picture, as there is the recognition of the fact that the international oil market is constantly evolving, with continually shifting fundamentals. For most of the time, such changes are barely detectable. But, as we have seen over the past 15 months or so, they can be very apparent — or, at least, the possibility that there has been a significant shift in fundamentals can be very apparent. [This is because, even now, in this most recent case, it is not totally clear whether there has been a significant shift in market fundamentals, let alone the true nature and extent of such an occurrence.] There is also the fact that, in the final analysis, the oil market is prone to volatility — as has been demonstrated repeatedly in the past, as well as at the present time. This is the exact opposite of what is required from a commodity that has such a central role to play in the modern world.

Let us look at Article 2C of the OPEC Statute to help define some of the parameters that OPEC considers as appropriate for stabilisation: “Due regard shall be given at all times to the interests of the producing nations and to the necessity of securing: a steady income to the producing countries; an efficient, regular and economic supply of petroleum to consuming nations; and a fair return on their capital to those investing in the petroleum industry.” [There is also another important parameter and that is the assurance of steady, predictable demand; this is often overlooked by consumers, but, for producers, is as important and as fundamental as security of supply, especially when one is weighing-up investment options for the future. Security of demand goes hand-in-hand with security of supply.]

Let us now turn to the other half of the title of this address: “Oil prices: to the sky …?” This prompts us to ask: “How high is the sky?” We also find ourselves engaging in the issue of real and nominal prices (I shall elaborate upon this a little later). (Slide 3) Some people with long memories will recall that, at the beginning of the 1980s, some analysts were predicting crude oil prices, in nominal terms, of US $100 a barrel by the year 2000! In fact, our records show that the nominal price of OPEC’s Reference Basket was not even a quarter of that — $23.89/b — on 31 December 1999! Even now, in these highly unusual times, the Basket price penetrated the $50/b mark for the first time ever in only March this year.

OPEC, like all producers, does not want excessive oil prices in either direction, high or low. Nor does it want volatility. We remember how, after the high prices and volatility of the 1970s, there was a big switch away from oil, especially OPEC oil, in the first half of the 1980s, so much so that prices weakened at first and then collapsed in 1986. In July of that year, the price of OPEC’s Reference Basket — projected back, because this reference yardstick was introduced in January 1987 — fell well below $9/b, and this compared with an annual average of $32.4 in 1982. In a period of just six years — from 1979 to 1985 — OPEC crude oil production declined by more than half, and only now is it approaching its pre-1980 levels — after a quarter of a century. The big loss of production, coupled to the price collapse, struck a double blow to OPEC’s Member Countries, whose domestic economies had become heavily dependant on the receipt of steady, viable petroleum revenues to finance their much-needed economic and social development programmes.

There are other downsides to excessively high oil prices — in the context of the international oil market. (Slides 4 and 5) Notably, these can distort the distribution of returns from oil sales, with, in many countries, particularly in Europe, consumer governments benefiting the most, through the receipt of higher levels of extra revenue, from taxation, than either the producers or the refiners receive. It is interesting to note that, averaged across the last five-year period (2000–04), the oil tax revenues of the G-7 countries were significantly higher than OPEC’s oil export revenues. Indeed, only in 2004 was there a change in the situation, in the wake of the high oil prices, but this was only to a slight degree and because, for that year, tax revenues grew by less than export revenues. (Slide 6) But the international oil companies (IOCs) stand to benefit the most. Last year, the five largest IOCs saw their revenue increase by more than $250 billion.

I should now like to tie all of this in with what is actually happening in the oil market at the present time.

(Slide 7) Over the past year or so, we have seen how quickly volatility and steeply rising prices can occur, following an extended period of relative stability — even when the market is well-supplied with crude. An unusual convergence of factors has been responsible for this.

(Slide 8) First, there has been strong global economic growth and a consequent big rise in the demand for oil, (Slides 9 and 10) especially in China, and, globally, this has led to concern about the near-term availability of spare production capacity. This is in spite of the fact that, throughout, the market has remained well-supplied with crude. (Slide 11) While the higher and apparently sustainable economic growth has no doubt contributed to some extent to the price levels we are seeing today, what is of more significance is the recognition that serious problems downstream in key consuming regions are increasingly putting pressure on crude prices. These problems have been due, in great part, to inadequate past investment and increasingly stringent product specifications, and have resulted in a lack of effective global refining capacity to meet the growth in demand for light products; this is now running at close to 100 per cent in practically all regions. Adding to the market nervousness have been the geopolitical tensions in some producing areas, as well as unexpected weather patterns, most notably Hurricane Katrina at the present time. Overall, the resultant bullish state of the market has led to a rise in activity by non-commercials, in particular pension and index funds in futures markets, leading, in turn, to further volatility and higher price levels.

Clearly, there are no winners from such a situation. It can have an adverse effect on activities at all levels within the market and, ultimately, have negative repercussions for both producers and consumers. (Slides 12–14) Volatility can be highly detrimental to investment, either for domestic development or in future production capacity — in addition to the day-to-day workings of the market-place. If prices are so high that they cannot be sustained, they may well be followed by very low prices and reduced revenues not long afterwards.

(Slide 15) Of course, “high” is a relative term. Although prices have recently been at record-breaking levels in nominal terms, if we put them in their proper historical context, we will find that, in real terms, they are well below those witnessed two decades ago. [In other words, when we adjust for inflation and exchange rate movements, we find that the average nominal price of around $36/b for the OPEC Reference Basket last year would, in real terms, correspond to a price of $80/b in 1982. In addition, one must be aware of the fact that the world, especially the developed part, has become much wealthier since the early 1980s.]

Moreover, there is no evidence that the recent high oil prices have, so far, had a significant impact on economic growth, which continues to be robust. If there is one lesson we have learned from the exceptional oil market conditions of 2004, it is that the world economy has become less sensitive to oil price increases than it was three decades ago. Indeed, despite another 50 per cent rise in oil prices so far this year, there has been no visible impact on economic growth. If anything, it is economic growth that has been driving up oil prices, rather than the other way round.

Important here is oil intensity — the amount of oil required for a unit of GDP. Across the world at large, this has fallen by around 50 per cent since 1970, due to such factors as technology, government policies and changing consumer behaviour. Thus the world is less dependant on oil for its economic growth. There is, however, no room for complacency.

In response to the present volatility and high prices, OPEC has acted on two broad fronts. (Slide 16) First, it has raised its production ceiling on several occasions, by a total of 4.5 million barrels a day, and this has been reflected in actual rises in its production. (Slide 17) This has, in turn, led to a steady rise in OECD commercial oil stocks, which are exceeding their five-year average, in both absolute terms in days of forward cover. And secondly, OPEC’s Member Countries have accelerated their plans to bring on-stream new production capacity. These actions have been taken, in spite of the fact that the market — a pretty nervous market — has been well-supplied with oil throughout this period. In fact, without such prompt OPEC actions, it is hard to imagine where the market would be today.

Our latest projections show that the average level of world oil demand will rise by 1.6 mb/d to 83.6 mb/d in 2005, compared with 2004, and then by another 1.6 mb/d in 2006. (Slide 18) But, unlike in the 1980s, the 1990s and the early part of this century, non-OPEC supply will not rise in line with this; instead, it is projected to grow by only 0.9 per cent in 2005 and 1.3 mb/d in 2006. Indeed, for the third year in a row, the growth in non-OPEC supply is falling behind that of world oil demand, and this new trend is expected to continue at least into next year. (Slides 19 and 20) Russian supply growth has almost vanished.

(Slide 21) Average OPEC production capacity is now expected to rise to 32.7 mb/d this year, and this will be well above the 28.9 mb/d call on OPEC.

Early forecasts for 2006 see world oil demand rising by another 1.6 mb/d to 85.2 mb/d and non-OPEC supply growing by a slightly lower 1.3 mb/d to 56.0 mb/d. This will leave a difference of 29.2 mb/d, which is 300,000 b/d above that of 2005. However, average OPEC production capacity is expected to rise to 33.9 mb/d in 2006. As a result, average OPEC spare capacity for the year should stand at around ten per cent, which will reflect favourable historical proportions and compares with around eight per cent expected for 2005 and 6.6 per cent in 2004.

Furthermore, OPEC has accelerated plans to increase crude production capacity to meet the expected growth in demand further in the future, with production capacity growing by 3.5–4.0 mb/d between 2006 and 2010, in addition to gains of 1.5 mb/d in the production of OPEC natural gas liquids and other liquids (Slide 22). Therefore, we are confident that, through OPEC’s actions, there will be enough crude in the market to meet robust oil demand growth in the near future.

(Slide 23) However, the efforts of OPEC and non-OPEC producers to increase capacity upstream stand in sharp contrast to developments in world refinery capacity, where increases have lagged well behind demand growth and the rises in OPEC and non-OPEC crude supply. Corresponding efforts need to materialise downstream, where, in some regions, refiners are currently running at 98 per cent or close to full capacity. OPEC Member Countries have taken the initiative — on their own and in partnership with others — to pursue and invest in downstream projects. However, without meaningful and timely measures in the main consuming countries, the high and volatile oil prices noted in the recent Group of Eight communiqué are likely to remain a feature of the market.

[It is clear from everything I have said so far that OPEC and its Member Countries are totally committed to an orderly oil market, with stable prices that are at reasonable levels acceptable to producers and consumers alike. Indeed, if there were not such acceptability, then the market would not remain stable for very long.]

[Our experience has shown us that it is considered perfectly acceptable within the market at large to talk in terms of a target range for prices. The price band scheme OPEC introduced in the year 2000 ran very successfully until last year, when the exceptional market conditions shifted the goalposts, so to speak, so far that we decided to suspend it, for re-evaluation. For those of you who do not know, the purpose of the price band was to keep oil prices within a range of $22–28/b for the Reference Basket, through OPEC adjusting its production level whenever it looked as if prices were settling outside this range. The scheme worked so well that, across the three full years of its operation, 2001–03, the Basket price average $25.2/b, which was almost exactly at the centre of the band. But let me stress that the band has only been suspended and that it is planned to reintroduce it, with a new, carefully calculated and realistic range, when the market settles down again.]

Let me now say a few words about the future, because OPEC is as committed to market stability in five, ten or 15 years’ time as it is today. Indeed, decisions taken today will affect the way the market performs in the future.

(Slide 24) The reference case scenario from OPEC’s World Energy Model shows that global oil demand will continue to rise up to 2025, at an annual average rate of 1.5 per cent, to 111 million barrels a day. More than three-quarters of the increase will come from developing countries, whose consumption will almost double. This scenario is based on the assumption of an average annual world economic growth rate of 3.5 per cent for the period up to 2025, with the forecast rate of almost 5.0 per cent for the developing countries being double the OECD’s projected 2.4 per cent.

(Slide 25) There should, however, be plenty of oil around to meet this demand. (Slides 26 and 27) The world’s oil resource base is not a constraint, and this is not likely to become even an issue for decades to come.

Overall non-OPEC output will continue to increase, but more slowly, reaching a plateau of 55–57 mb/d in the post-2010 period; this represents a rise of 5–7 mb/d from 2004.

However, OPEC’s Member Countries, with around four-fifths of the world’s proven crude oil reserves, have both the capability and the will to continue expanding their oil production capacity to meet the rising levels of demand. Averaged out, a dollar of investment in the OPEC area yields more than four times as much production capacity as a dollar of investment elsewhere. In 2025, the reference case, therefore, sees OPEC meeting almost half the world’s oil demand, with 55 mb/d.

The overall scale of investment required for all of this will run into hundreds of billions of dollars in the coming decades, although, globally, it will not be very different to past levels.

(Slide 28) Numerous possibilities for investment exist, although recently a move towards more involvement from the international oil companies in the upstream activities of some OPEC Member Countries has been observed. However, other Members might choose to meet the investment challenge through their national oil companies, or they could do it in partnership with the IOCs. Of prime importance will be the establishment of fair and workable agreements, reached through open and transparent procedures. There will have to be adequate incentives for the investor, yet suitable protection and recompense for the owner of the resource. And there will have to be a clear commitment to sustainable long-term development by the IOCs in setting up partnerships.

(Slide 29) But clouding the picture for investment are many uncertainties about the market outlook, on both the demand and supply sides. Notable drivers of uncertainty are future economic growth rates, consumer government policies, technological advances and the oil price path. It can prove very costly if the industry does not get its sums right. Over-investment may result in excessive, idle capacity, while under-investment may lead to a crude shortage. Both cases can create severe price volatility.

(Slide 30) Increasingly, attention is being turned increasingly to investment in the downstream, in the same way as we are placing more focus on this part of the supply chain for the near term. The move towards demand for ever lighter and cleaner products represents a significant challenge for the downstream sector, and substantial investment will be required to meet this in the years ahead. As with the shorter term, if the required investment does not take place in a timely manner, this sector will remain a source of volatility and tightness. (Slide 31) As it stands now, it does not appear that the growth in refinery capacity will match demand growth before 2007.

Excellency, ladies and gentlemen,

I hope I have used this time well to impress upon you how seriously OPEC takes the issue of order and stability in the international oil market, for both now and the future.

Speaking to an audience which contains His Excellency Mr Per Kristian Foss, the Norwegian Minister of Finance, and key executives from the Nordic energy industry and associated sectors, I am sure this message has been well understood and appreciated. As the world’s third-largest oil-exporter, and the largest among the established market economies, Norway is better placed than most to appreciate the challenges facing the industry as a whole. On top of this, the country is also the world’s third-largest gas-exporter.

Over the years, OPEC has placed great value on the support its market-stabilisation measures have received from Norway, particularly at critical times for the industry, and this has been to our mutual benefit. (Slide 32) We also welcome the fact that Norway — like OPEC itself — has been a prime mover in producer-consumer dialogue. Indeed, Norway has provided the first Secretary General of the International Energy Forum, Mr Arne Walther, and the Secretariat of this still relatively new specialist producer-consumer institution has been set up in an OPEC Member Country, Saudi Arabia.

We believe that such common areas of interest, attitudes and actions have already served the industry well, and that they will continue to do so in the future.

(Slide 33) Thank you.

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