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The Crude Oil Trade And Opec Economics Essay

The way in which crude oil trade is carried out changed since the 1970’s, when OPEC took charge of the global market and oil price. The question of who has access to crude oil, in what quantity, at what price and for how long emerged since then. (Mohnfeld, 1980)

Control and market power has gradually shifted from the hands of consuming countries and their international oil companies, into the hands of producing countries since the 1970s. The big international oil companies until 1973 were in control of the international crude oil trade. A few number of oil companies, regarded as “common suppliers” had access to crude oil directly. Large volumes of crude oil not required for their own operations were sold to other participants in the market (e.g. independent refiners, traders and other integrated oil companies of different sizes). (Mohnfeld, 1980)

OPEC however, became the power behind producing countries since the early 1970s as they demanded for a greater share in the profits obtained from oil production and also for more participation in the operations of the oil companies producing in their countries. This control commenced in 1972 with total-take over in Iraq and Iran (1973), where the state company, NIOC seized complete control of all areas of oil production. (Mohnfeld, 1980).

Today, participation range from 50 to 100% and producing countries, despite their equity share, have total control over crude oil price and production volumes. After 1973, private oil companies were able to gain access to most of the oil of the previous concessions via buy-back agreements and long-term production agreements with producing countries. Hence, international oil companies were still responsible for the sale of a large proportion of crude oil, despite losing a large share of their concessions and equity interests in the production of crude oil. The volume of crude oil available to the seven largest international oil companies (the majors who formed the “seven sisters”) before the Iranian crisis of 1978 exceeded that required by their own affiliates. While these companies supplied varying volumes of crude, they still had a combined surplus of about 3.7mbd that they sold to third parties. This was however affected by the cessation of exports from Iran. This deprived the majors of a high volume of crude oil that was almost equal to the aforementioned surplus. The majors were individually and differently affected by the Iran cut-off but it affected the entire oil industry through interconnecting supply contracts. The majors’ third party contracts were reduced or phased out, applying the principle of force majeure and their long-term policies were revised. The former status of the consortium formed by the “seven sisters” was never restored, even after crude oil exports gradually resumed in Iran because the old agreements were cancelled by the new government. Changes in pattern of crude oil trade also occurred in producing countries such as Nigeria, Saudi Arabia, Venezuela, Iraq, etc. In these countries, productions of the international companies were reduced to favor their state companies and private independents which previously had little or no direct access to crude oil. (Mohnfeld, 1980)

There was a relative stability of oil prices up until 1973, when the U.S. were the major exporters of petroleum products. However, this ended when the OPEC member countries imposed their first price increase in order to gain from the high demand in some countries. This resulted in a 70% price increase that forced the non-OPEC countries to obtain their own aboriginal crude oil supplies. The production from non-OPEC countries grew gradually and coupled with OPEC’s goal of maintaining its price limit by restricting production, a situation was created and by mid-1980’s, oil price began to drop. (Seba, 2008)

OPEC imposed high crude oil prices during the time of the crisis (oil shocks) in 1973 and 1979 because they controlled most of the production and the demand for crude was very high. This aroused new exploration and development which eventually made OPEC lose its ability to dictate world oil prices. In order to still influence oil prices, OPEC set up a quota system (production sharing) to monitor production from member countries. This involved an upper limit of daily crude oil production that must not be exceeded. (Seba, 2008)

Though OPEC members agreed on production sharing, they did not stick to the agreed limits for each member and the cheating members, in order to maximize profits, started selling on the spot market, where prices were determined by a different method. (Foster, 1987).

The world oil price sequence from 1970 shows two periods of startling price increase of long duration. The first rise was from less than $3/bbl to over $12/bbl and this took place between 1973 and 1974 during the Arab oil embargo. This increase was permanent as the price of oil never dropped to $3/bbl again. The second price increase occurred during the Iranian Revolution in 1979. Oil price rose to almost $40/bbl from about $15/bbl. This did not last long as price began to fall gradually in 1981 until 1986 when the first main crash in oil prices occurred. (Inikori et al, 2001)

OPEC, though created in 1960 rose to international height in the 1970s as member countries took charge of their own petroleum industries and obtained a major say in oil prices on world markets. At this time, the price of oil increased which led to increased supply but demand did not reduce due to influences of other market forces. (Inikori et al, 2001)

In the early 1980s, there was an excessive supply of crude oil which resulted in the fall of oil price. Then demand increased slightly above supply in 1985 when oil price slightly increased. From 1985 up till 1997, there was a good relationship between demand and supply, and oil price demonstrated a linear trend except for occasional price hikes such as that which occurred during the Gulf war crisis in 1991. Generally, any basic change in demand or supply is reflected in the price structure. (Inikori et al, 2001)

At the start of 2008, oil price was $92/barrel, then in July 2008 the price rose to over $140/barrel and six months later fell to $33/barrel. OPEC attributed the rise in oil price to huge investments made directly and indirectly by non-commercial investors aiming to obtain exposure to commodity markets, rather than to supply and demand functions. The collapse was caused by the global financial crisis that started in the U.S. and spilled to other countries, the sudden drop in economic activity in developing countries and the recession in Organization for Economic Cooperation and Development (OECD) countries as they choked demand. (OPEC, 2009)

Crude oil price, though not fixed by producer nation is affected by their production strategies. A small change in produced volume can result in a relatively large price change. For example in 1987, a 4% change in supplied quantity of crude resulted in a 50% change in price and in March 2000, a 7.5% increase in produced quantity resulted in a 30% price reduction with a supply elasticity of less than one in both instances. (Inikori et al, 2001)

OPEC had a great control over oil prices and got the highest rate of cooperation from its members in the period from 1973 to 1985. From the mid 1980’s members began to disagree on production quotas and OPEC became incapable of maintaining cooperation from its members. Therefore, they were unable to reach and enforce agreements, even though they met regularly. (Gregory, 2008)

Understanding the sources of past oil prices, helps in knowing what may happen in the future. The oil market is now a bit free of constraints than before. It has changed to become like other markets, with prices changing in response to supply and demand. (Robinson, 2001).

Making precise statements about the future is unwise as the future is essentially uncertain. Rather than the crude oil scarcity expected by many people, it is more likely that the cost of extracting crude will increase as higher cost crude will need to be extracted in the future. Consequently, prices will rise, resulting in problems for producers and consumers. (Robinson, 2001).

But we cannot fully know if the future will be similar to the past. Extraction costs may fall continuously for a long time, and the anticipated price rise will not occur. (Robinson, 2001).

The uncertainties concerning the future demand levels for oil and energy, coupled with the world economic situation are the root cause of the encompassing challenge facing the oil and gas industry and OPEC especially. (OPEC, 2009)

As a result of the recent fall in oil price, supply from non-OPEC countries have reduced and OPEC is expected to continue to supply crude. If this continues, OPEC spare capacity will continue to reduce and price is expected to react to this as a similar situation occurred in 1998/1999 when the low prices caused capacity shortage that led to the price rise in 2004-2008. Low prices usually presage unsteady markets and price rise. (OPEC, 2009).

Globally, oil trade along with other commodities will experience changes until 2015 as it is anticipated that there will be decline in crude oil exports. But beyond 2015, oil trade will commence its growth and by 2030, trades between regions would increase by about 12million barrels/day, rising from 54.6million barrels/day in 2015 to over 66million barrels/day in 2030. (OPEC, 2009).

Summary

The events that occurred in the 1970’s have generated sudden and permanent changes in the petroleum industry, including oil prices. (Seba, 2008).

Before the formation of OPEC, the oil majors who formed the “seven sisters” multinational companies ruled over the international oil market. (Inikori et al, 2001). They determined the way in which crude oil was traded and they also controlled oil prices. But the producing countries demanded for more participation and profit in oil production from their countries. This resulted in OPEC, who was the force behind them, taking control of the oil market for some time. OPEC however lost this power due to the lack of cooperation from its member countries.

The crisis in the 1970’s had a great impact on the world’s crude oil demand. The yearly demand of 7.4% per year for oil that existed in the previous years, suddenly dropped to 0.5% per year and has continued that way ever since. This goes a long way in affecting oil price. Supply and price of crude oil will be affected by OPEC’s quota changes. (Seba, 2008). Also, as long as OPEC members do not adhere to agreed production quota, oil prices will continue to fluctuate. (Foster, 1987).

To be able to predict the future trend of oil prices, the issue of scarcity needs to be addressed but since this cannot be fully determined, oil prices will continue to fluctuate and will not follow a particular trend. (Robinson, 2001)

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