The Capitalist | Will the oil production cut help Opec again?

The Capitalist | Will the oil production cut help Opec again?
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First Published: Thu, Oct 30 2008. 11 10 AM IST

Updated: Fri, Oct 31 2008. 04 29 PM IST
Last Friday, the Organization of the Petroleum Exporting Countries (Opec) decided to cut production by 1.5 million barrels daily— or 75 million tonnes (mt) a year— in the hope that it could arrest the fall in oil prices. It may be recalled that crude oil prices plummeted from a peak of $140 (Rs6,972) a barrel in July this year to just $64.34 last Friday. Despite the announcement, prices kept climbing down to $63 at the time of writing this column.
Opec likes to believe that it can arrest the fall in oil prices. It realized its clout four decades ago, when it suddenly increased the price of oil, giving the world its first oil shock. Then it did so again in 1996-97 when it hiked the price of oil by $6-10 a barrel. This continued periodically, and prices went up in 2007 as well. But the increase in prices during October 2007 and July this year was dizzyingly steep (see chart). Till the decline began.
Also See Yearly Production and Historical Oil Prices (Graphic)
Opec wants prices to stay above $80 a barrel—almost at the level they were at in October 2007. Venezuela wants them at $95. Iran, which subsidizes oil prices at home, wants them high, because they fund its military plans. But the markets have currently kept them at the same levels they were in March-April 2007.
So will the production cutback work? There are two views. Opec believes it will. But many market watchers say they won’t. The primary reason is the declining clout of Opec. Over the past four decades, the organization’s share in the world’s oil production has declined from three-fourths to just 40%.
Moreover, thanks to the attractiveness of oil prices, even at $40 a barrel, the prices are attractive enough for many more countries to keep investing huge amounts for discovering and producing more oil and gas. And this investment trend continues with increasing ferocity, especially in Russia, Kazakhstan, the Arctic regions, India, Indonesia, Malaysia (where many Indian companies have taken up exploration and drilling rights) and offshore regions of both North and South America. This is likely to push down Opec’s share even further. It is the classic Achilles heel of producer monopolies. When prices become attractive, other producers emerge, creating more supply and more competition, thus further weakening a monopoly.
Many market watchers agree. “We expect oil prices to remain around $70 a barrel,” says Yudhishthir Khatau, managing director, Varun Shipping Co. Ltd, whose ships are largely in the oil and gas transportation business. He, like many market watchers and economists, says that three factors will not allow oil prices to climb much higher in the near future. First, oil stocks in most countries are healthy. Second, because this is the lean season for oil consumption, though prices could strengthen during the winter months. Third, recession in Europe, China, and the US may force reduced offtake of oil.
Also See Opec Production (Graphic)
Even Opec sources confirm that they did not expect consumption to fall so drastically during the past two months. The first factor is worsened by the jettisoning of oil by most tankers which were floating with oil cargo during March-June, confident that soaring oil price would generate more profits than what they would earn as freight charges. When the slide in oil prices began towards end July, tankers began jettisoning their cargo, adding to oil reserves. This caused tanker freight charges to fall though, as Khatau clarifies, oil tanker charges did not fall as steeply as did the Baltic freight indices (which reflect dry cargo shipping, not oil and gas tankers).
There is another reason why the production cutback may not work this time. Contrary to popular perception that Opec did everything to maintain supply during the oil price climb of 2007 and 2008 (when oil prices were soaring every week), freshly available data shows that Opec did try and reduce production even then (see table). That did help inflame speculators and flare up prices for some time. But that strategy did not work for too long.
Almost every Opec member country reduced production in 2007 (over 2006) and in 2008 (annualized). Add to this the reduction in production by countries such as Mexico (which is not part of Opec) and this number is likely to swell further. A notable exception was Iraq, where pumping stations were under the supervision of the US Army. Iraq increased production by 7mt in 2007 and is expected to register an additional increase of another 13.5mt in 2008 (over 2007 on an annualized basis). High oil prices encouraged many countries to increase their own output and make more oil profit. A big beneficiary was Russia, which not only seized control of oil fields from its oligarchs (and private investors) but also pushed up production from around 480.5mt in 2006 to 491.3mt in 2007—a whopping addition of 10.8mt. (no figures for 2008 are available yet). In fact, oil profits allowed Russia to pay off most of the debts from its 1998 financial crisis. And, as the BusinessWeek points out, “It also built up a $560 billion in reserves and an additional $160 billion in two sovereign wealth funds financed from oil taxes.”
Moreover, given the acute global recessionary trends visible all over the world, marketmen wonder if many countries will be bold enough to cut back on oil production in the coming months. If not, Opec’s decision could remain ineffectual.
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Deficit financing defies logic
Deficit financing in India has begun to worry many economists.
While finance minister P. Chidambaram tries to glibly explain this away as being due to a global downturn, the fact remains that the government has been profligate in its spending.
Losing out: An oil platform being constructed for ONGC. Some of its most lucrative oilfields were given away almost 15 years ago to favoured firms under the first phase of the New Exploration Licensing Policy. Santosh Verma / Bloomberg
More worryingly, this deficit does not include almost Rs2.5 trillion (figures vary from Rs2 trillion upwards) subsidy that the oil companies have notched up thanks to government policy.
Oil bonds have been kept out of this deficit figure. Add this figure and the picture becomes even more alarming.
According to Fitch estimates, if all off-budget subsidies were accounted for on-budget, the general government deficit would approach 9% of gross domestic product (GDP) in 2008-2009 (FY2009).
Meanwhile, the (largely government-owned) oil companies continue to bleed for the want of cash-flow, though the reduction in oil prices will help reduce this pain.
However, a weakening rupee will offset some of this benefit.
The even bigger fear is that once oil companies become weaker, the government may find an excuse to give them away to the private sector players, in much the same way as the government gave away some of the most lucrative oil fields belonging to Oil and Natural Gas Corp. Ltd almost 15 years ago to a clutch of favoured companies under the first phase of the New Exploration Licensing Policy— no tenders, no independent valuation; just the plain transfer of public assets.
Some call it another instance of the privatization of profits and the socialization of losses.
But more about this later, as it warrants a more detailed analysis.
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Sovereign anxieties on shifting investments
Sovereign wealth funds (SWFs) are shifting investments away from the US and Europe and into West Asia and other Asian economies. Moreover, they have also shifted their investments from finance companies to (surprise! surprise!!) real estate, but in emerging economies.
These are the finding announced by the Massachusetts-headquartered Monitor Group last fortnight, as part of its update to its June 2008 report Assessing the Risks: The Behaviors of Sovereign Wealth Funds in the Global Economy.
Some of the findings:
# SWFs continued to invest actively in emerging markets. In the second quarter (Q2) of 2008, more than half the deals and funds invested were in emerging markets. SWFs carried out 26 deals and invested $15 billion (Rs74,700 crore) in Bric (Brazil, Russia, India and China) and non-OECD (Organisation for Economic Co-operation and Development) countries.
# In Q2 2008, funds in the Monitor SWF transaction database executed 43 deals totalling $26.5 billion. In contrast, those funds executed 42 deals totalling $58.3 billion during the previous quarter.
# Investment in North America dropped dramatically. In Q2 2008, four deals totalling less than $1 billion were received by North America. In contract, this region received seven deals totalling $23 billion during the previous quarter (Q1 2008).
# Half of the deals by value in Q2 were in real estate. Real estate had the largest number of deals (12) and the highest investment ($13.7 billion) in Q2 2008.
# During Q2 2008, investment has shifted away from financial services. SWFs carried out 10 deals and invested $4 billion in the financial services sector during Q2 2008. In the previous quarter (Q1 2008), funds carried out 13 deals totalling $43.4 billion. With the disenchantment with the US, does this suggest that the dollar will weaken in the near future?
R.N. Bhaskar runs a company with significant interests in distance learning and examination certification and writes on corporate and business policy issues. Comments on this column are welcome at capitalist@livemint.com.
Graphics by Paras Jain / Mint and Ahmed Raza Khan / Mint
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First Published: Thu, Oct 30 2008. 11 10 AM IST