Elephant in the room: How OPEC sets oil prices and limits carbon emissions

Abstract

Despite a North American oil boom, non-OPEC crude oil production is not increasing, because new production roughly balances existing oil field decline. This situation allows OPEC, which has spare production capacity, to control the total global oil supply and therefore oil pricing. OPEC has raised crude oil prices by a factor of about four since 2002, reducing world demand. Thus, world crude oil production has been flat since 2005, and a major source of carbon emissions has been capped. This production plateau has been maintained in spite of significantly increased demand from China, India, and other developing countries. But governments in both developed and developing countries could reduce emissions more efficiently and fairly by putting in place, for example, a zero-net-revenue surcharge regime for fossil fuels, with all collected funds returned directly to consumers.

It is a fundamental tenet of the oil business: Petroleum is forever. While old wells and fields may be exhausted and abandoned, a new giant discovery is always just over the horizon. In 2004, however, one oil company broke ranks and, with refreshing candor, discussed oil as a finite resource. In its report ¹ “The Outlook for Energy: A View to 2030,” the Exxon Mobil Corporation stated that crude oil production outside the Middle East—that is, from those reserves that don’t belong to the 12 members of the Organization of the Petroleum Exporting Countries, or OPEC—would peak by about 2010, remain constant for several years, and then begin to decline. ² Based on this forecast, ExxonMobil decided that it would build no new oil refineries, because increasing supplies of non-OPEC petroleum would not be available (Nauman, 2005). The report also noted that demand for liquid fuels would continue to grow and that Middle Eastern producers could be expected to increase production to supply the growing market. ³

Although unstated in the report, it was evident that, after 2010, OPEC would fully control future oil supply increases and that prices could increase quite substantially. This would have profound consequences for the economies of the United States and the rest of the industrial world, as well as for those societies hoping to transition to a Western standard of living. Despite the alarming implications, the forecast was ignored by almost everyone—including governments, consulting groups, and environmental organizations.

While ExxonMobil did not explain the basis for its projections, the company probably made use of data from the US Geological Survey’s World Petroleum Assessment 2000, which evaluated world oil resources using the best available science—engaging experts not only in government but also in intelligence agencies, petroleum companies, and petroleum consulting groups. ⁴ The assessment was by far the most credible study of its kind ever done. ⁵

It is now more than eight years since the ExxonMobil projection was made, and well beyond 2010—the approximate peak year for non-OPEC oil as predicted in the report. It is appropriate to ask many questions, starting with the obvious one: Was ExxonMobil correct? One of the hazards of making short- or long-term forecasts, especially about the oil business, is that the future can make fools of the most astute and capable observers, to their enormous embarrassment, due to advancing technology or other factors that were neglected or could not be imagined. ⁶

As it turns out, ExxonMobil was correct about the peak in non-OPEC crude oil output. Based on data provided by the US Energy Information Administration, annual average non-OPEC conventional crude oil production increased by 16 percent over 10 years, from 36.3 million barrels per day in 1994 to 42.1 million barrels per day in 2004, and then over the past eight years has remained very close to this level. ⁷ Thus, non-OPEC production indeed reached a peak, or at least a plateau, if somewhat sooner than predicted. Given all the uncertainty involved in making such an estimate, this result should be regarded as a major triumph for ExxonMobil.

Despite all the frenzy about a North American oil boom, non-OPEC crude oil production is not actually going up, because new production is roughly balancing declines at existing oil fields. Policy makers, analysts, and the news media alike have failed to recognize that, given this production reality, OPEC still controls not only the final total global oil supply but also oil pricing. In fact, the organization has been raising oil prices and reducing demand for oil since 2003, and this demand constriction has also greatly reduced greenhouse gas emissions. Although any dynamic that reduces carbon dioxide emissions helps slow climate change, OPEC’s control of oil prices and demand has negative side effects, and it is clear that governments could limit greenhouse gas emissions more efficiently and fairly through a zero-net-revenue surcharge or fee on fossil fuels, coupled with rebates to consumers affected by higher fuel prices.

How big oil works

To appreciate the profound significance of the non-OPEC crude oil peak, it is necessary to understand, in a general sense, how the world oil industry functions. Crude oil is the backbone of the petroleum industry; other liquids such as ethanol, biodiesel, and natural gas liquids (petroleum liquids obtained as a by-product of natural gas production) are included in world oil statistics but have a much lower energy content and a smaller resource base, and will not be able to replace crude oil. Unconventional crude oil—oil derived from tar sands, heavy oil deposits, oil shale, and the conversion of natural gas and coal to oil, as well as shale oil ⁸ produced using newly developed rock-fracturing technology—is difficult to extract and will add only marginally to world oil output. These other resources will probably prolong the plateau in liquid fuel production but will not be a replacement for conventional crude oil.

Non-OPEC producers currently supply about 57 percent of crude oil. There are several categories of non-OPEC producers: publicly or privately owned and operated companies such as ExxonMobil, BP, and Shell; national oil companies such as Pemex (Mexico’s state oil company); and quasi-national companies such as Petrobras (Brazil) and CNOOC (China National Offshore Oil Corporation). These diverse organizations share the same objective: to find and produce as much oil as possible, as quickly as possible—and to make as much money as possible while doing so. There are no production quotas for any of these organizations. Rather, there is intense, cutthroat competition to find new oil deposits and begin extraction with all deliberate speed. Profits are derived almost entirely from exploration and production; refining and distribution of petroleum products are much less lucrative, so there is an intense focus on successfully locating new oil deposits. Given the market rules under which these producers operate, a peak in non-OPEC production means that it must be physically impossible for these organizations to increase oil production through new discoveries or by using improved technologies to extract previously inaccessible oil. Otherwise, they would produce more oil.

Decline rates: The hidden killer

Discovery of new oil fields is necessary not only to meet rising demand but also to compensate for declining production in mature fields. Oil companies often announce in glowing prose the discovery of new fields—for example, in the Gulf of Mexico or offshore Brazil. They also tout the hydraulic fracturing of oil-rich shale formations in North Dakota and Texas, efforts widely portrayed as a bonanza for the United States that heralds a revolution in world oil production.

There is, unfortunately, an elephant—or perhaps a parade of elephants—in the room. It is seldom mentioned that production from all these new resources barely compensates for the decline in existing non-OPEC fields, where production is going down by approximately 7.1 percent per year, according to a study published by the International Energy Agency (2008). Moreover, decline rates can be expected to increase as large, easy-to-discover fields are exhausted and smaller, harder-to-find deposits are exploited.

Oil from unconventional deposits will not alter the situation substantially. Canadian crude oil production, including that from tar sands in Alberta, is expected to increase by 1.5 million barrels per day between 2012 and 2022 (Energy Resources Conservation Board, 2013). US crude oil production is projected to increase from 5 million barrels per day in 2008 to 7.5 million barrels per day by 2019 and then gradually decline (US Energy Information Administration, 2012). Even though US crude oil production increased by about 1.38 million barrels per day between 2008 and 2012, non-OPEC oil production remained essentially flat over this period. Thus it appears that crude oil from these unconventional sources will only help to lengthen the leveling-off of liquid fuel production and not significantly increase the overall rate of production.

Increased extraction from these new resources through 2020 should be compared with the minimum production decline of conventional crude oil—at least 24 million barrels per day ⁹ —over this same period. So while some oil companies stand to profit handsomely from these new reserves, market fundamentals remain unchanged.

OPEC producers

OPEC, which currently supplies 43 percent of the world’s crude oil, is formally committed, as described in its founding statute (OPEC, 1961), to maintaining a stable market; this is something that non-OPEC producers cannot and do not worry about. That is, the organization keeps demand and supply in balance and keeps prices within a band that it deems reasonable. To achieve this balance, it may increase or decrease production as needed. Each member country has a production quota based roughly on that country’s proven reserves, as well as on other factors such as its need for revenue. However, these quotas are mostly for public consumption, and members may or may not abide by them. The only result that really matters is a tranquil market.

OPEC always maintains what is termed “spare capacity,” which is the ability to send additional supply to markets on short notice in case of unforeseen developments. For example, when Libya’s output dropped by 1.65 million barrels per day as a consequence of the Libyan civil war that began in February 2011, increased production from Saudi Arabia, Kuwait, Iraq, Qatar, and the United Arab Emirates (UAE) replaced the Libyan output by August of that year, with negligible disruption to the world economy. In another example, OPEC decreased production by about 3 million barrels per day between July 2008 and January 2009 following the near-collapse of the world financial system and the onset of the Great Recession; non-OPEC production was virtually flat during this period. Had OPEC not cut production, prices would have fallen enough to drive many non-OPEC producers into bankruptcy.

Although rarely mentioned in discussions of oil prices, the existence of spare capacity gives the organization control of the market price band for oil. This is set far above the cost of extraction, which for OPEC oil is a few dollars per barrel.

It is important to note that all market participants influence day-to-day or week-to-week prices on commodity exchanges. This includes businesses such as airlines or oil refineries that need to protect themselves from changes in prices, as well as speculators who place bets on future price shifts. For example, if a refinery has an accident, an oil tanker is attacked, or there is a report of an excess of oil stocks in the United States, speculators moving in or out of the market can immediately increase or decrease the market price of oil. Longer-term prices, however, are essentially controlled by OPEC: Too much supply in the market means prices will drop slowly but steadily, and too little supply means prices will rise. ¹⁰ In either case, there can be significant fluctuations within or outside the price band because there is no official cooperation between consumers (oil importers) and producers to balance the market. Indeed, price fluctuations can be viewed as an integral part of the price-setting mechanism in that they help to mask the real reason for price increases.

The oil weapon: Unmentioned but potent

OPEC sets prices due to geopolitical as well as economic considerations and never announces or explains its decisions. ¹¹ Nonetheless, one can make reasonable guesses about the motivation behind some short-term price movements. For example, the organization might not want gasoline prices to be an issue in US presidential elections and could adjust production to ensure stable prices at such times. Also, unexplained oil price increases are an effective way to send a message. That is, while certain OPEC members might not favor a nuclear-armed Iran, even less desirable would be a US or especially an Israeli attack on that country. It could well be that the spikes in oil prices in 2007–08 and 2011–12 were directly related to the threat of an attack on Iranian nuclear facilities.

Finally, oil prices dropped significantly following the financial panic in 2008, not necessarily because OPEC was unable to decrease production sufficiently to support higher prices but perhaps because OPEC did not want to be seen as contributing to the strain on Western economies. This is conjecture, but the important point to understand is that OPEC controls the market price band and is willing to use its control to achieve its own economic and geopolitical goals.

To the average American gasoline consumer, price signals are confusing over the short or intermediate term, and memory can fail completely for changes taking place over more than six-month periods. However, it is precisely these longer-term trends that are most relevant for understanding the second part of ExxonMobil’s forecast, that of increased crude oil production by OPEC.

OPEC’s choice: Increase production or increase prices

Once non-OPEC production reached a maximum, OPEC had a choice. It could increase production, maintaining the prevailing price band; this was the outcome expected by ExxonMobil. Or the organization could limit its own production and increase prices to bring demand and supply into balance. This latter course of action has many advantages. It requires minimal investment in new fields, conserves a finite resource, and allows income to rise much faster than it would with a production increase.

Beginning in about 2003, OPEC chose to increase prices rather than production. World crude oil production reached 73.7 million barrels per day in 2005 and remained near this level through 2011. ¹² The peak in non-OPEC production is the result of physical limitations on the ability to extract more oil, but OPEC members—especially Saudi Arabia, Iraq, Iran, and the UAE—are believed to have very large proven and undiscovered reserves and could increase their output significantly if they decided to make the necessary investments. OPEC production limits are consciously chosen, rather than dictated by available resources, and have been of enormous benefit to both OPEC and non-OPEC producers, as well as to the overall health of the planet.

Since petroleum is a fundamental requirement for a modern industrial society, raising prices is a delicate matter. Consumers would like prices to be as low as possible and based on the discovery and extraction cost, which for the Middle East is well below $5 per barrel. ¹³ Resource owners would like prices to be set as high as possible and based on the value extracted from oil by the user. For example, it is well known that people will pay dearly for personal mobility. In Europe, where prices are predominantly determined by taxes, customers pay $8 per gallon for gasoline, even with crude oil prices at about $110 per barrel ($2.62 per gallon). ¹⁴ This demonstrates that governments, rather than producers, capture much of the value of imported oil (OPEC, 2012).

In addition, an abrupt price increase (Yergin, 1991)—such as was announced by OPEC in 1973 ¹⁵ —should be avoided since consumers and industry will need time to adapt, either with new technology or changes in lifestyle. In recent years, demand has been restrained by gradual price increases, not by interrupting supplies; indeed, over the past two decades OPEC has never mentioned or in any way suggested a supply disruption.

The organization has continued to increase prices since 2003, with a pause due to the onset of the Great Recession. In 2002, the year before the US invasion of Iraq, the annual average OPEC crude oil basket price ¹⁶ was $24.36 per barrel, and OPEC spoke openly of increasing or decreasing its production to maintain oil prices within a band of $22 to $28 per barrel. ¹⁷ However, after the US invasion of Iraq in March 2003, mention of this approach became less and less frequent and finally disappeared completely. ¹⁸

It appears that OPEC, far from being cowed into submission by a display of overwhelming military force, took the Iraq War as an opportunity to increase prices gradually. Between 2002 and 2012, its annual average basket price increased from $24.36 to about $110 per barrel, or by a factor of about four, an astonishing accomplishment. This far exceeds the US rate of inflation during this period (a factor of approximately 1.3) but has had a relatively tolerable impact on the world economy; the gradual change has allowed consumers to adapt, while the Great Recession has cut demand in the developed world.

Initially, industry analysts and commentators explained oil price increases by saying that the markets were reacting to the unrest in the Middle East by adding a “war premium,” or “terrorist premium,” or “fear premium,” to prices. ¹⁹ Some even attempted to quantify this premium by conjuring up a sum to be added to what analysts thought the real price should be. There was little basis for these calculations, and any “premium” was in effect pulled out of thin air; one might as well have proposed a “leprechaun premium” to explain the escalating prices. At one point an OPEC spokesperson simply stated that he did not understand why oil prices were so high since the markets were obviously well supplied (Reuters, 2008).

More recently, OPEC and others have blamed “speculators” for price increases, a brilliant choice given the terrible damage that banks, hedge funds, and other financial buccaneers and their enablers have inflicted on the world economy. Speculators are the perfect scapegoat, if the goal is to distract consumers, politicians, and environmentalists from OPEC control of the market, as well as from the root cause of the problem: physical limits on petroleum resources.

Anyone familiar with how oil markets function can see through this charade, yet it has been a success in that OPEC has remained nearly invisible and is seldom cited in the news media as having a central role in setting oil prices. Non-OPEC oil companies do not challenge this narrative because they profit enormously from it. Most environmental groups and consumer organizations lack the expertise or the will to penetrate the misleading rhetoric from authoritative sources, and in any case are largely focused on the problem of climate change. To a casual observer it would seem that prices are determined by free markets, since large volumes of oil are traded daily on commodity exchanges. These markets do serve useful functions, but setting the price band for oil is not one of them. There should be no doubt that OPEC can and does control oil prices based on what it regards as its own economic and strategic best interest.

The climate connection

OPEC’s decision to increase oil prices and thereby limit demand, rather than to increase production, has another important consequence: It puts a cap on a major source of greenhouse gas emissions and, by encouraging the owners of other fossil fuel reserves to raise prices and thus reduce demand, reduces emissions still further. The question is whether demand will continue to increase so the price hikes can be maintained, and whether there is any possibility of satisfying the increased demand from available oil resources.

Increased demand

Demand for oil is increasing rapidly in the developing world, in particular in India and China. These two nations have a combined population of about 2.5 billion people and are moving rapidly toward more comfortable lifestyles, including the much wider use of automobiles. To understand what this means for world oil markets, consider what a European level of oil consumption would mean for India and China: Average petroleum consumption in Western Europe is about 10 barrels per person per year; equivalent consumption in China and India would require 25 billion barrels of oil per year. (By comparison, average US consumption is about 22 barrels per person per year.) Current world oil production is approximately 32 billion barrels per year, and an increase of 25 billion barrels per year, or some 70 million barrels per day, is out of the question. (Africa and Latin America are following this same path and hope to improve their standard of living in precisely the same way.)

Both China and India are diligently following Western development templates and seem completely unaware of the unfeasibility of the “business as usual” model. It appears that the world is on a collision course not only with limits on petroleum resources but also with limits on economic growth fueled by increased supplies of oil. China and India clearly cannot consume petroleum at the same level as Europe, much less the United States; the resource base just does not exist, even if Middle Eastern oil producers decided to maximize output.

This most certainly means that nobody will be able to consume petroleum or other fossil fuels, even at current, modest European rates, for much longer, and we will all be forced to adapt to significantly higher fuel prices. Fortunately, it does appear that while renewable energy supplies are more expensive than fossil fuels, they are certainly affordable and will allow most people to live comfortably; the world is not going to freeze in the dark.

OPEC is thus sensibly using increased prices to limit demand, a classic case of “demand destruction.” For all practical purposes, the world will never run out of oil: Price will be used to ration a scarce commodity, and there will be oil for sale at, for example, $500, or $600, or $800 per barrel. Moreover, natural gas prices are linked to oil prices everywhere outside the United States, so a similar process is taking place with this fuel.

Policy implications

It has become evident over the past decade that most consumers are incapable of voluntarily reducing their fossil fuel consumption, even when told that the stability of the Earth’s climate is threatened. It is therefore important to explore all possible means of motivating people to move away from fossil fuels.

It is generally agreed that a zero-net-revenue carbon surcharge is the fairest, simplest, and most effective way to reduce fossil fuel consumption. While there is strong resistance to such a surcharge, it should be noted that the $2-per-gallon price increase OPEC imposed between 2002 and 2012 is approximately equal to a carbon tax of $200 per metric ton. ²⁰ This indicates another way to persuade people to move away from fossil fuels: immediate economic necessity due to high fossil fuel prices demanded by the owners of the resource.

While an effective carbon tax imposed by the resource owners is infinitely better for the climate than no tax at all, it is far from ideal. The resource owners in this scenario collect all of the revenues; a far better approach would be to recycle at least a portion of the effective tax to consumers, to subsidize new technologies. It remains to be seen whether politicians are willing to acknowledge resource limitations and use this as a justification to impose, for example, a zero-net-revenue surcharge ²¹ on fossil fuels.

In any case, it may well be that price increases dictated and collected by resource owners alone ²² will be sufficient to move society toward a more sustainable economy and to avoid the worst consequences of our insatiable demand for fossil fuels.

A new approach to oil pricing and taxes

It appears that oil companies as well as hedge fund operators and investment houses are aware of the immediate reality of finite oil resources. This scarce commodity will be rationed through prices set by OPEC, the owner of the largest and lowest-cost reserves. Higher prices will encourage the development of alternatives, such as new technologies and lifestyle changes. OPEC leaders seem well aware of the challenges they face and so far have carried out their strategy of price rationing with consummate skill. This set of circumstances also presents an opening for others who wish to limit fossil fuel consumption to mitigate climate change; hopefully, they can use the facts related to oil supplies and pricing to persuade citizens and, particularly, leaders of developed countries that they must deal with petroleum differently if they are to maintain an acceptable standard of living on a crowded planet.