June 8, 2015 / 12:47 PM / 2 years ago

COLUMN-OPEC adjusts to new oil market reality: Kemp

(John Kemp is a Reuters market analyst. The views expressed are his own)

By John Kemp

LONDON, June 8 (Reuters) - OPEC has never really been a "cartel" in the conventional sense of an organisation that agrees to restrict output to maximise revenues.

So its decision on Friday not to cut production was entirely predictable and the only practical option open to its members.

The strategy of maintaining production even as prices fall, led by the Saudis but now more or less embraced by most of the organisation's membership, is really the only sensible course.

Most traders sense this: the price of Brent for delivery in December 2015 has been virtually unchanged since February and barely moved on Friday.

If the organisation was confronted by a temporary shortfall in demand it might make sense to cut output to secure more revenue.

But faced with a permanent shock from the supply side, such as the shale revolution, and the permanent loss of demand from substitution and conservation, the organisation's only sustainable response is to continue pumping and allow the market to adjust.

Attempts to buck the market always end in failure, a lesson top Saudi officials and others in OPEC have learned the hard way over the last 50 years.

OPEC OBJECTIVES

According to its founding statute, the Organization of the Petroleum Exporting Countries, to use its full name, was established in 1960 to coordinate and unify the petroleum policies of its members (Article 2(A)).

The organisation also seeks "ways and means of ensuring the stabilization of prices ... with a view to eliminating harmful and unnecessary fluctuations" (Art. 2(B)) as well as a "steady income" for producing countries and a "fair return" on capital for investors in the oil industry (Art. 2(C)).

OPEC ministers confer regularly and typically announce their decision in the form of a collective production target and sometimes allocations (colloquially termed "quotas") for individual member countries.

This has given rise to the myth that OPEC is a cartel that has successfully raised prices by restricting the amount of oil that its members produce.

"OPEC has ... achieved a reputation that embraces extremes of response," Ian Skeet, a former Shell executive, wrote almost 30 years ago. "It has been commended, reviled, supported, opposed."

"It has been variously envied and derided for the transfer to itself of hundreds of billions of dollars, and for having been, or not been, a successful cartel," Skeet explained ("OPEC, twenty-five years of prices and politics" 1988).

The reality, however, has been very different. OPEC has only intermittently and with limited success behaved like a cartel. Its power over the oil market has been vastly exaggerated.

During its first decade, OPEC was almost exclusively concerned with raising its share of oil revenues by taking ownership of the oilfields and increasing taxation on operating companies.

Most OPEC members raced to increase their output as quickly as possible.

In the 1970s, members turned their attention to coordinating prices and discounts but were still free to pump as much as possible.

It was not until March 1982 that OPEC began to announce a collective production target and allocations for individual member countries ("OPEC Annual Statistical Bulletin" 2014).

For the last 33 years, the organisation has announced a collective target but has not always been able to agree on individual allocations and the target has sometimes excluded certain member countries such as Iraq.

There have been only three periods when members agreed to restrict production significantly to remove supply from the market and achieve higher prices: 1984-1986, 1998-2002 and 2008-2010.

Even in these periods, the cuts for most members were notional, with widespread cheating and non-compliance. Real cuts fell almost entirely on Saudi Arabia, Kuwait and the United Arab Emirates.

Other members such as Iran and Iraq have consistently rejected production restraints because they need to maintain government income and pay for defence-related expenditures.

At its most powerful during the oil shock of 1973/74, OPEC accounted for half of global oil production. But its share since the 1980s has generally been no more than around 40 percent.

If OPEC has ever really behaved like a cartel, it has been a very incomplete one.

"Unless it controlled the world's entire production, it could not possibly maintain the new status quo forever. Sooner or later other producers would challenge it," historian Stephen Howarth wrote about the organisation's problems with rival producers in the 1980s ("A century in oil" 1997).

EXTERNAL SHOCKS

The big shocks in oil prices over the last 50 years have all originated outside the organisation. In 1973, it was the exhaustion of spare capacity in the United States after two decades of very low prices which set the stage for the oil shock.

In the 1980s and 1990s production from newly developed fields in the North Sea, Alaska, the Soviet Union, China and the Gulf of Mexico which depressed prices for around 15 years.

In 1997-98, the Asian financial crisis depressed demand sending prices below $10 per barrel. In 2004-2008, it was booming demand in Asia, and especially China, that sent prices soaring above $140.

Most recently, the global financial crisis and now the shale revolution in North America have sent oil prices plunging.

In all these instances, OPEC and its members have been forced to adapt to market conditions rather than driven them.

The organisation has been most successful when it accommodated itself to changing supply and demand conditions rather than tried to fight them.

Efforts to change prices by restraining supply have generally failed and left member countries with both lower prices and lower market share (1982-85) or succeeded only in the short term (1998-2000 and 2008-2009).

Faced with the shale revolution in the United States, which has unleashed a wave of mid-priced crude onto the market, Saudi Arabia and the rest of OPEC have taken the only sensible course open to them: do nothing.

The oil market will gradually rebalance. There are signs that the process is already well underway. Demand will grow much faster than when prices were over $100 per barrel while new investment in supply will be curbed.

The major producers around the Middle East Gulf will continue to increase their production though they will see sharply reduced revenues.

Shale producers, too, will survive, though the industry will be forced to become more efficient and some of the highest cost and most speculative projects will be abandoned.

The real burden of adjustment will fall on the highest cost and most risky projects which are caught in the cross-fire.

The North Sea, the Arctic and OPEC's own weaker members in Africa and Latin America will all struggle to attract investment and maintain let alone grow output in a low-price environment. (Editing by David Evans)

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