Understanding OPEC: Cheaters Never Win

Baseball is a frustrating sport, and not just because there's all that standing around waiting for something exciting to happen. No, it's frustrating because unless your home team is the Yankee's, you're at a disadvantage. See, the Yankee's have more money than God, and therefore, they simply play the game by a different set of rules.

OPEC is the Yankees of the oil market. This not-so-secret society sits on 80 percent of the world’s oil reserves, and is responsible for 51 percent of the oil that's traded internationally on any given day. On paper, it wields enormous power over the world economy, and thus, any investor in the energy market should hang on every word coming out of the Cartel's whenever-we-feel-like-it meetings in Vienna.

Unfortunately for OPEC, it's not so simple. Unlike the Yankee's, OPEC us not led by a sometimes-benevolent dictator. In fact, it is not led by anyone, and it is not the all-powerful man-behind-the-curtain it is made out to be. OPEC is best understood as polite gentleman's oil salon -- an exclusive, members-only club where the elite discuss the markets in which they make their millions, and construct an MBA experiment in the prisoner's dilemma.

Designed To Be Ineffective

OPEC stands for the Organization of the Petroleum Exporting Countries; not, as some believe, the Oil Price Elevation Cartel. In fact, it's only in the broadest definition that OPEC can even be considered a cartel. They don't fix prices; they don't actually regulate anything; and their sole stated function – the setting of production quotas for its members – is both voluntary and unenforced.

For the last several years, as oil prices have risen and plateaued, OPEC has been functionally irrelevant. There have been no production quotas in place. All bets were off, and OPEC members simply pumped as much oil as they could get out of the ground and sold it as fast as they could. It was only as oil dropped below $60/barrel last October that OPEC agreed to cut production by 1.2 million barrels a day—a significant cut on the 30 million barrels being pumped daily by the group.

But OPEC is designed to be ineffective. Unlike Columbian drug cartels, there's no curtain of fear, crime, and death to descend upon errant members. Historically, OPEC resolutions on production have been violated at will. During the 1980s and 1990s, for instance, average OPEC production was 20 percent higher than the “official” quotas.

These quota violations generate more than angry phone calls from one oil minister to another. Iran refused to accept quotas in the late-1990s as a political protest against Saudi Arabia's actions after the first Gulf War. And because a given country's quota is determined by proven reserves, gamesmanship among the members is the primary sport between meetings.

Prisoner’s Dilemma

The best way to understand the basic problem OPEC faces is to consider that old standard of economic theory, the prisoner's dilemma. In the classic prisoner's dilemma, two prisoners are given the choice of ratting out the other guy, or keeping silent. If both remain silent, they will both receive a light sentence. If they both betray their compatriot, they will both receive a harsher punishment. But if one squeals and the other remains silent, the silent conspirator will be severely punished and the squealer goes free. The optimum decision is for both to remain silent, but the individual decision to confess is the more prudent choice, absent a means of collusion.

OPEC suffers a similar dilemma. If all the OPEC countries really did cooperate – and if that cooperation could be known and enforced – then managing production would allow OPEC to wield tremendous power, ensuring that prices stay at a point that produces the optimum profit for all of its members. But cutting production means a loss of real revenue on the day you implement those cuts. You hope to make it up by selling at a higher price tomorrow, but the incentive is always to see if you can get away with just slipping a little more out into the market. You know, just enough for another Gulfstream or two. And because OPEC votes are anonymous, even if you plan on cheating, you can claim you were behind production cuts all the time.

The only reason OPEC hasn't fallen into complete irrelevance is the steady hand of Saudi Arabia. As the largest producer in the organization, Saudi Arabia has played the good cop. Because they have the most to lose from plummeting prices (and the most to gain if OPEC works), they exercise self-restraint and actually cut production when its time to cut production, all the while knowing the smaller members will cheat. It's a broken system, but for the OPEC members, it's worth the trip to Vienna and the $2 million bucks in dues per year.

(Oddly, it's the environmentalists who may have the most to gain from a strong OPEC. All of OPEC's hand wringing and hair pulling is designed to do one thing—to keep the price of oil as high as reasonably possible. And high oil prices are precisely what spurs the growth in hybrids, biofuels and conversation. If oil prices drop back to, say, $10 a barrel, R&D budgets would be slashed and corn would go back to being cow feed and breakfast syrup, not fuel for your Ford truck.)

OPEC And Investors

The question for investors is: is OPEC's presence in the market is a good thing or a bad thing? OPEC claims that it work is for the good of humanity—that it efforts remove volatility from the oil market. That’s nearly impossible to prove or disprove, but looking at oil prices, their capabilities are in question. OPEC announcements may impact the market during the short-term, but if you want to get under the skin of the oil market, you’re better off paying attention to the actual producers. There, any of number of factors—political turmoil, work strikes, natural disasters—can have a real impact on supply.

Here’s the short list.

The Steady Core

Saudi Arabia
Saudi Arabia is the big stick in the oil market. They sit on one fifth of the world's proven oil reserves—about 260 billion barrels. Most of it is good oil, too—light and sweet.

The oil industry in Saudi Arabia is nationalized—Saudi Aramco controls 98 percentof the country's oil reserves, and is the largest producer in the world at 11 million bbl/d (and growing every year). Because of this raw physical dominance, when obstacles get in their way of Saudi production, it is news.

One obstacle we’ve been hearing a lot about lately is a big one: depletion. Existing Saudi oil fields have been decreasing output 6-8 percent yearly, and its oldest field is estimated at 74 percent depleted. Aramco claims that reserves are underestimated, but given decades of quota wars (with quotas tied to estimated reserves), that seems tough to swallow.

Just as important as its raw oil wealth is the fact that Saudi Arabia is the monster economy of the entire Middle East, and a huge source of stability for the region. Oddly, perhaps, what stability there is in the world’s oil markets is largely due to a political system anathema to most Americans—Saudi Arabia is one of the world’s only true monarchies. (Note: There's no “constitutional” in front of the big M: the sons of Victorian-era King Abdul Aziz have ruled the country with absolute authority since 1932).

United Arab Emirates
From an oil perspective, the UAE is essentially Abu Dhabi, which has 95 percent of UAE’s 100 billion barrels of proven reserves. With production at 2.5 million bbl/d, the UAE is a shadow of Saudi Arabia, but as a collection of religious monarchies, they've also provided phenomenal stability in the region's markets.

Qatar
Tiny Qatar sits on 15 billion barrels of prove oil reserves, with just a quarter million citizens (you do the math). The country is essentially a support mechanism for the oil business, and is ruled by a (comparatively) liberal monarch who seized power while his father while was away on a ski vacation in 1995. The country is considered stable enough that it is the U.S. military's home-away-from-home in the Middle East.

Algeria
Algeria is OPEC's good little soldier. Most American's probably can't find it on a map (hint – it's near Morocco), but it's got a nicely running parliamentary democracy. While it only spits out a little over 1 million bbl/d, the oil it produces is among the highest quality in the world – it is low sulfur and easy to refine. As the EU gets pickier about these things, Algeria's in a very good position.

The Uneven Neighbors

Angola
OPEC's newest neighbor only joined the club in January of 2007. While Angola produces a fair amount of oil (1.5 million bbl/d), production is expected to be at or near its peak. The country has been riddled with civil war for 25 years, and while theoretically a democracy, elections haven't been held since 1992.

Iran
It's a big day when Iran isn't in the headlines. The country relies almost entirely on oil exports to fund heavy state subsidies on fuel and food, and has rampant inflation and unemployment, which is born out by unrest and surging fundamentalism in the younger generation. The political environment could best be described as “fluid,” and the oil industry is less than stable, with most of the infrastructure in need of improvement. Iran remains a wild card—not just as a political entity, but as an oil producer.

Iraq
We all know more about Iraq than we ever thought we would in high school. What most of us don't realize is that even though Iraq, and the Army Core of Engineers, have brought production back up to 2 bbl/day, Iraq's true oil wealth is still a bit of an unknown. At least two-thirds of the country has never been explored for oil, and only a handful of the known oilfields have actually been developed. For these reasons, Iraq's role on both the world stage and in OPEC is all about the future.

Kuwait
Known mostly as the staging point for the two Gulf Wars (and the raison d’etre of the first), Kuwait sits on somewhere between 5 and 10 percent of the world’s reserves. These sky-high numbers, however, come with caveats. Kuwaiti oil is heavier and more laden with sulfur than many of its neighbors, and estimates of reserves have been plagued with intrigue and internal scandal.

Libya
Like Iraq, much of Libya's oil potential remains unexplored, yet it still kicks out 1.5 million bbl/d. Most of it goes right to Italy, across the Mediterranean. Ruled essentially as a military dictatorship since Mu'ammar Qadhafi took power in an 1969 coup, the country is one of the most bizarre political experiments in history. Theoretically based on a kind of anti-fundamentalist socialist/Islamic government, it is in fact run through relatives and committees controlled by Qadhafi, who holds no formal government office. While Libya's oil wealth is controlled through a national company, it continues to aggressively seek international corporate partners.

Nigeria
The most populous country in Africa, Nigeria is also painfully poor, with 70 percent of the country’s population at- or near starvation levels. The country produces almost 3.5 million bbl/d, but anti-government militias have severely hit Nigeria's capacity, and have threatened all-out war against oil companies in the Niger Delta. Because Nigeria supplies a substantial portion of U.S. oil, daily headlines from the front lines can have an impact on oil prices that can be lost beneath the high-profile Middle East news Because of the chaos, Nigeria has frequently ignored OPEC quotas. It pays watching

The Fringe Elements

Indonesia
Indonesia is huge. More people live in Indonesia than anywhere on the planet outside the U.S., China, and India. And as a huge nation, it uses a lot of oil.

Back in 1962, Indonesia was the poster child for a developing nation with a national resource to sell, and it exported large quantities of oil. But today, Indonesia is actually become a net importer of oil (begging the question how long it can meet the definition of OPEC membership). While some of this is due to its own economic expansion, Indonesia's production has been in decline since the 1990s.

Politically, Indonesia has been a democracy on paper for decades, but it has faced near constant political turmoil, revolution and rebellion. The country was the hard hit by the East Asian financial disaster of 1998, and it's yet to recover. Crippling poverty means that the government not only imports oil, it spends substantial portions of its Treasury on subsidies for fuel. Indonesia simply can't take much more pressure, and has ceased to be relevant as an OPEC member.

Venezuela
Venezuela should get a place of honor at the lunatic fringe of OPEC politics. President Hugo Chavez was elected by a large margin in 1998 on the basis of his plan to rewrite the constitution—in essence, a revolution by election. Following a recession in 2002, Chavez was nearly ousted as opponents sought early elections, and most of the country's oil industry went on strike. The impact on the Venezuelan economy was massive, and only the rise in oil prices brought the country back from the financial brink. Even so, the situation remains tenuous: the recent oil strike set the country back years in production growth, as the national oil company fired nearly 20,000 oil workers.

Despite being the largest exporter in the Western hemisphere, Venezuela only accounts for 10 percent of U.S. imports. The hard reality is that even the big boys on our side of the Atlantic are still small when compared to the Goliaths of the Middle East and Africa. But the political name-calling between Chavez and President Bush keeps Venezuela in the headlines, and this often has carryover into short term oil price movements.

Comments

[Georealist]

From my perspective this is fairly interesting information but largely irrelevant. OPEC isn't benevolent or maelvolent..in fact, it's anachronistic. OPEC reminds me of the United Nations....it pretends to do things it has liitle if any influence over. OPEC and the UN both have similar enforcement mechanisms against groups doing things they don't like..they meet and whine. What is Saudi Arabia going to do if Venezuela "cheats" on an agreed upon quota? Spank Hugo Chavez?
As the oil/gas world sorts itself out..and OPEC member nations come up against their real reserve limits, vital infrastructure issues and the bleak (for more than a few) prospects of funding their huge subsidized social systems into the future they will INDIVIDUALLY do what they must to survive. Every one of OPEC's members will have to have is a very individualized plan for energy market survival.
For investors, what this means is.....don't be distracted by structures that pretend to have power. Look at oil depletion scenarios as they are unfolding around the world. What used to be a highly secretive process isn't so secretive any more. Look at the state of the delivery infrastructure...Who makes the stuff? Who can install it? Who can REALLY keep it working? I can guarantee you it won't be 2nd and 3rd world technical underachievers.