Since August 1990, OPEC has been living in a dream world. For the last year and a half, 6 million barrels per day (bpd) of production capacity have been off the market: Iraqi output has been embargoed, Kuwait’s oil facilities were destroyed and the largest non-OPEC producer, the former Soviet Union, has suffered serious production shortfalls. Despite full-throttle production in most OPEC countries, oil prices have stabilized at relatively high levels. But as Kuwait prepares to return to the market, with Iraqi exports looming on the horizon and oil demand growth depressed by poor economic conditions worldwide, OPEC once again faces its historic dilemma of controlling supply voluntarily and stabilizing oil prices at a level that provides for the minimal revenue needs of member states.
OPEC oil ministers gathered in Geneva in February to discuss one issue: how much would they individually need to cut to avoid creating oversupply conditions that could cause a price crash. In the best of circumstances this is not an easy assignment. Saudi Arabia and the United Arab Emirates (UAE), whose excess capacity allowed them to raise output rapidly in the wake of the Iraqi invasion, are resisting pruning their production, demanding that other members bear a proportional burden of any output cuts. The patched-together agreement that emerged in February clearly demonstrated how adamant the rest of the club were in not letting Saudi Arabia get its way.
Ups and Downs
Oil prices began to decline from their historic highs by 1982-1983, forcing OPEC to institute a voluntary output reduction system through assigning individual quotas. The idea was very simple: World demand (X) was calculated, non-OPEC supplies (Y) were assumed, and the call on OPEC supplies (X-Y) became the output ceiling, then divided among the members.
But the system failed to stem the price slide. By 1995, average spot prices had fallen to about $25 from $32 per barrel. Saudi Arabia adhered to the official price system, but most other OPEC members “cheated” on their quotas, pushing the burden of adjustment onto Saudi Arabia. In 1979-1980, Saudi Arabia produced over 10 million bpd or 36 percent of OPEC total; by mid-1986 it was down to 3 million bpd, approximately 20 percent of the OPEC total. In early 1986, Saudi Arabia abandoned official prices and switched to a netback pricing system, whereby purchasers were guaranteed a certain refining margin. In doing so it recaptured a significant market share from the rest of OPEC: The sharp rise in crude oil supplies prompted spot prices to crash from $28 per barrel on the average in 1985 down to $14 per barrel in 1986 (the average masks a low of around $5 per barrel in June and July). The Saudis had used their “oil weapon” — significant excess capacity combined with adequate financial reserves to cushion the blow of lower revenues — to establish some discipline in OPEC.
OPEC then agreed to a new set of quotas tied to a basket price target of $18 per barrel. By late 1986 and early 1987, prices rose to around $18 per barrel for West Texas Intermediate and $15-$16 per barrel for the OPEC basket (from well below $10 in early in 1986). The Saudis were able to impose an important condition on other members following the 1986 crash: In return for agreeing to an $18 per barrel price objective, Riyadh insisted on a guaranteed quota of approximately 25 percent of total output.
This became the center of controversy within the organization for much of the period leading up to the Iraqi invasion of Kuwait. A revival in oil demand growth rates in the industrialized world between 1988 and 1990 allowed OPEC to nudge prices above $18 per barrel. Some members called for expanding OPEC’s ceiling by a smaller factor than anticipated demand growth, in effect pushing oil prices up further. Those who argued for this policy — the price hawks — were those countries that had begun to encounter oil output capacity constraints. For them the only way to increase total revenues was through higher prices. A long-term factor motivated the so-called price doves, in addition to concerns about sustaining demand growth in the industrialized world. Lower prices depressed the value of downstream oil assets (such as refineries and gas stations) worldwide. This allowed Kuwait, Saudi Arabia and Venezuela to buy up refining and distribution capacity nearer to consuming markets to help ensure a long-term market share. It also gave them the ability to take profits at stages other than crude output, making their total revenues less dependent on the crude selling price.
The 1990 OPEC Meeting
There were doves among the doves within OPEC. Regional political and economic concerns sometimes prompted the Saudis not to push prices down too far. Then-Vice President George Bush’s visit to Riyadh after the 1986 price crash was a case in point. In 1988 and 1989 King Fahd publicly guaranteed that Saudi Arabia would strive to keep oil prices at $18 per barrel. A key reason for this was the Iran-Iraq ceasefire in 1988: Riyadh wanted to maintain oil prices at levels that ensured Baghdad would be consumed with rebuilding rather than threatening its neighbors. This goal was formally consummated in the Iraqi-Saudi Non-Aggression Pact signed in 1989.
The biggest battles in OPEC prior to 1990 were between Saudi Arabia and its two small Gulf neighbors: Kuwait and the UAE. Both refused to keep to their quotas, and added an additional 1 million bpd to overall OPEC output. In 1989 the market largely ignored this over-production, but by early 1990 it had contributed to mounting international crude inventories. By the second quarter of 1990, traders on the New York Mercantile Exchange pushed West Texas Intermediate prices down to $15 per barrel.
A tour of the Gulf in June 1990 by Saddam Hussein’s special envoy, Sa‘doun Hammadi, halted the slide in prices as Iraq unveiled its own “oil weapon.” Thirty thousand Iraqi troops along the Kuwaiti border helped Baghdad dictate the final agreement at the OPEC ministerial meeting in July, which respected Saudi Arabia’s 25 percent market share and allowed the UAE to raise its quota to 1.5 million bpd, while setting an overall ceiling of 22.5 million bpd. Iraq demanded that the OPEC reference price be raised to $25 per barrel and that no further change in overall quotas be allowed until this price level had been exceeded. A compromise was set at $21 per barrel.
Saudi Arabia played a largely passive role at this July 1990 meeting, content to see Iraq humble Kuwait. Kuwait reduced its oil output (even before the meeting) and appointed Rashid Salim al-‘Umari, an unknown chemistry professor, as oil minister to replace Sheikh ‘Ali Khalifa, the architect of Kuwait’s aggressive oil policies.
If Iraq had not invaded Kuwait, this is where we probably would find OPEC today. Instead, Iraq provoked the massive US intervention and lost its new power within the organization. Behind direct US protection — Saudi output did not rise to replace embargoed Kuwaiti and Iraqi exports until the first American troops had arrived in the Eastern Province — the Kingdom’s production rose to 8.5 million barrel per day, or 35 percent of OPEC’s total output.
The US-led military campaign allowed Riyadh to regain its status within OPEC. Until this latest meeting in February, Saudi Arabia dictated final agreements with virtually no opposition. Others have had little to complain about as they have been producing at capacity and prices have remained relatively high. Saudi Arabia has generally adopted a fairly cooperative stance with other members, notably Iran. This harmonious relationship owes a lot to Iran’s desire to be seen in the West as an important and “responsible” member of OPEC. Iran is looking to attract investment both for its oil — Iran has some of the most liberal petroleum and gas investment laws in the Middle East — and other industrial sectors. Tehran’s recent and rapid rise of foreign debt (mainly short-term) can only be sustained if Iran gains access to long-term borrowing from industrial country export credit agencies and commercial banks, which in turn depends on the country’s ability to expand its foreign exchange receipts.
The February 12 meeting was slated to be a venue when the old dove/hawk battles would revive. At issue was whether to reinstate the July 1990 agreement, suspended following Iraq’s aggression. The hawks wanted to restore the quota system and the reference price embedded in that agreement. Since many members exceeded their output ceilings, the expected return of Kuwait and Iraq to the oil market necessitated a return to the pre-invasion rules and regulations if prices were not to fall sharply.
Saudi Arabia’s aim at the February meeting was the opposite: to eradicate the last vestiges of the 1990 quota shares — especially Saudi Arabia’s 22.45 percent share. A prospective second quarter 1992 slide in oil prices gave Saudi Arabia an opportunity to ram through a new agreement which would ratify its claim for 35 percent of OPEC’s market share. The Saudis were so intent on achieving this goal that they would have compromised on a lower overall quota, even lower than the 22.8 to 23 million bpd it was publicly willing to accept, possibly even to the Iranian proposal of 22.5 million bpd.
Conceding the bigger issue of market share for a remunerative short-term agreement was the dilemma facing poorer members such as Iran and Venezuela. Any reasonable forecast of the oil markets pointed to only a nominal increase in demand, along with potential production increases from Kuwait and former republics of the Soviet Union. A fixed Saudi share of 35 percent thus implied stagnant or reduced shares for other members.
After four days of meetings, the Iranians and other OPEC members refused to blink. The Iranians were clearly willing to risk improved political relations with Riyadh and absorb the oil price hit. Tehran is convinced that Riyadh does not want to push Iran back to the “bad old days,” even if that means foregoing unfettered dominance in OPEC.
The Iranians also believe that, unlike in 1986, Riyadh’s tight financial position means the royal family can only ensure domestic stability by maintaining civilian infrastructure and consumption expenditures, keeping its principal Western allies happy through military and foreign aid spending, and sustaining investments in the oil industry. This requires an annual income stream of at least $45-50 billion, or a minimum of 8 million bpd of oil production at $16-18 per barrel.
This income requirement, Tehran suspects, will keep the Saudis from “trashing” the market as they did in 1986. Riyadh may still use that threat to get others to share the burden of production adjustments, although the February meeting showed that other members are reluctant to allow the Saudis to formalize this burden sharing. Technically the final agreement was essentially what the Saudis wanted in the short run: total production ceiling of 22.982 million bpd, and a temporary quota level equal to 35 percent of the ceiling. They did not get their long-term objective: official and unanimous OPEC recognition of a 35 percent market share of all future OPEC output ceilings. Riyadh would have gladly sacrificed the short-term goal for the longer-term gains. This it will continue to strive for at subsequent meetings.