OPEC cuts production...Saudi ignores?

A truly interesting development out of Vienna this evening.

OPEC surprised markets this morning by announcing a 520,000 bpd cut in production. This reflected the concerns of certain members (Iran, Algeria) over the recent decline in commodity prices amid falling demand and the unwinding of financial positions. However, reports are that almost immediately the Saudis (who opposed the cut) were assuring markets that they would not abide by the decision.

This internal split is many years in the making, and reflects the competing interests/viewpoints within the cartel (essentially, Saudi v. all). Because of the Saudi position, markets largely shrugged off the announcement, believing that the kingdom would maintain current production levels.

These developments got me thinking: Does OPEC really matter anymore?

Since the oil shocks of the 1970’s, OPEC has been the dominant actor in the global oil markets. Currently, OPEC produces approximately 40% of global supply, and possesses about two-thirds of the world’s proven reserves. OPEC has also historically provided the spare capacity required to respond to demand spikes and shocks to the global system.

However, in recent years the cartel’s market power and influence has waned. Official statements like the one this morning have failed to calm traders, stabilize record price volatility, or move markets. Two particular measures of OPEC’s influence highlight its declining influence: as a provider of global spare capacity, and as a price setter.

As non-OPEC production growth has failed to keep up with accelerating global demand, OPEC has increased production to cover the shortfall. As a result, the cartel’s spare capacity has diminished. Most OPEC members (with the exception of Saudi Arabia) are now producing at near total capacity. In an environment of heightened political instability in oil producing regions, poor refining capacity, and robust Chinese and Indian demand growth, OPEC lacks the short-term flexibility to stabilize volatile prices. This decreases its authority and influence in the global market.

Like spare capacity, OPEC’s ability to set the price of oil has declined markedly. A number of factors have contributed to this change:

First, rapid demand growth across the developing world has increased supply concerns. The emergence of powerful new consumers in Asia has compounded fears that decades of underinvestment will result in a significant supply shortfall in the coming years. OPEC’s capacity to meet this rising global demand is in doubt.

Second, the growth of both regulated and unregulated over-the-counter exchanges has led to a massive increase in the amount of so-called “paper-barrels” traded. Consequently, financial speculation has become an important driver of the spot price. This diminishes the impact of OPEC production/quota changes on short-term prices. For example, Saudi Arabia’s recent announcement that it was increasing production by 700,000 bpd barely registered on the exchanges.

Finally, political instability in the Middle East has had a significant impact on the price of oil over the past 5 years. Instability in Iraq and Lebanon, the Iranian nuclear issue, and the threat of terrorism have all contributed to record price volatility. OPEC’s inability to ramp up production in response to politically-related price spikes affirms its diminished capacity.

While no longer the market mover it once was, OPEC remains the single most important actor in the global oil market. The fact that the cartel possesses the majority of the world’s proven reserves guarantees its staying power. Non-OPEC production is forecasted to decline rapidly, as alternative fields are geologically complex and difficult to operate. Russia, the world’s second-largest oil producer, last year witnessed its first year-on-year production decline in over a decade. The key challenge OPEC faces in the coming years may be its own internal disagreements, as reportedly playing out today. Despite these differences, the Saudis have always exercised leadership by adjusting their own production disproportionately to accommodate the self-interested actions of other members. As long as the Saudis retain the will to lead, overall unity should prevail.

Thus, while it no longer dictates the global oil market, OPEC remains an important actor whose influence should increase again in the coming years.