Ending oil volatility
Wildly fluctuating oil prices have sent shocks through the global economy in recent years. A formula exists to curb the worst of these tremors, writes Hussein Abdallah*
Adjustments resulting from the October 1973 War increased the price of oil from $3 to $11.65 per barrel starting 1974. Strengthened by the 1979 Iranian Revolution, the nominal price of oil was raised to a peak of $33 in 1981. Accounting for inflation and a devalued dollar, however, this price converts to only $15.55 in 1973 dollars, which we call "the real price of oil".
Oil-producers' control over production and pricing was short lived. In less than a decade, the US and Western industrialised nations designed and implemented plans to reclaim control. This resulted in erosion in prices during the early 1980s, ending in price collapse in 1986 from $28 to $13.50 in nominal terms, which was equivalent to only $5.50 in 1973-dollar value.
Consequently, actual OPEC production declined in 1986 to nearly 16 million barrels per day (bpd) from 31 million bpd in 1979 -- the year Western strategic oil storage peaked. This resulted in a shut-in of 15 million bpd of OPEC productive capacity. Competition among producers was intensified in order to activate the shut-in capacity and, together with Western- imposed policies lead by the US, brought prices down for a long period of time. Over the period 1986-2003, the nominal price of oil ranged around $18, while the real price did not exceed $5 in 1973-dollar value.
In the meantime, OPEC spare productive capacity (the shut-in capacity) decreased between 1986 and 2007 from 15 million bpd to 29 million bpd due to rising exports. Likewise, domestic oil consumption in OPEC countries increased from 3.4 million bpd to 6.4 million bpd. Consequently, the spare capacity was used up. Moreover, shrinking oil investments, due to falling prices, had no expansive impact on productive capacity. Declining oil prices and revenues, in both nominal and real terms, caused the financial surpluses of petroleum exporting countries to translate into growing debts covered by borrowing in the international capital markets.
With unprecedented global economic growth, oil demand grew from 78 million bpd in 2003 to about 86 million bpd in 2007, while spare oil capacity has been on the decline to reach nearly two million bpd, mostly heavy Saudi oil that is difficult to market due to weak demand for it. The shrinking spare capacity has an important upward impact on oil prices, since it is a significant factor in securing the availability of oil supplies in case of an unexpected disruption.
The imbalance in market fundamentals -- supply, demand, spare capacity and storage -- coupled with geopolitical tension in the Gulf, home of two-thirds of known global oil reserves, pushed the price up. Additionally, the recent weakness of the dollar encouraged speculators to shift to commodity speculation based on the paper barrel, which is traded daily in the world stock exchanges at more than 10 times the trade in real oil (or "wet barrel"). As a result, OPEC nominal prices skyrocketed from $28 in 2003 to $36 in 2004, $50 in 2005, $61 in 2006, $69 in 2007, and averaging $104 during the first half of 2008. In early July 2008, oil prices hit $140 per barrel before plummeting to $60 a day before the OPEC meeting of 24 October, which reduced its production ceiling by 1.5 million bpd.
This severe price volatility has been of paramount concern for both oil producers and consumers, and on top of such concerns was the question of how to accelerate and expand global oil productive capacity.
To attain "Global Energy Security", the G8 summit meeting in St Petersburg, Russia, July 2006, strongly called for oil capacity expansion. As recently as 22 June 2008, a high-level producer-consumer conference, held in Jeddah, Saudi Arabia, brought together representatives from many producing and consuming countries, as well as oil industry representatives. The participants noted, with concern, that current oil prices and their volatility are detrimental to the global economy, agreeing that the situation requires concerted efforts from all parties. They also recognised that the existence of spare capacity throughout the oil supply chain is important for the stability of the global oil market. Hence, an appropriate increase in investment, both upstream and downstream, was necessary to ensure that the markets are supplied in a timely and adequate fashion.
This immediately raised several questions: Is the call for oil capacity expansion directed to new wildcat exploration of oil fields, which would widen the base of proven reserves, or is the call only meant to develop already discovered but not developed fields, which would accelerate reserve depletion? And, in all cases, who is ready to finance and take the risk of such capacity expansion at a time of such severe price volatility?
These questions then translate into our focal question: Is there a more objective and stable formula for oil pricing that can set a floor for prices and reduce the severity of volatility caused by factors other than market fundamentals?
Yes, is the answer; there is one that is rooted in the early 1970s oil agreements concluded between OPEC and the international oil companies after a long series of intensive negotiations. Despite the fact that these agreements are no longer in effect, they may still provide guiding factors that serve in developing an oil pricing system that is more stable and less volatile than the current chaos.
Three factors were provided by these agreements. First, according to the 1971 Tehran Agreement, oil prices were to increase by an annual rate of 2.5 per cent to account for inflation. Second, the same agreement provided for a price increase at an annual rate of 2.5 per cent to compensate oil producers for the depletion of their non-renewable reserves. This rule was rooted in the American system that used to grant oil companies a tax benefit known as the "depletion allowance", in order to help them explore for and develop new oil fields to replace depleted ones.
Third, since oil is priced in the US dollar, the first Geneva Agreement, concluded in 1971, provided for oil prices to be adjusted according to changes in the value of the dollar vis-à- vis major international currencies. Therefore, the price of oil was raised by 8.5 per cent following the floatation and devaluation of the dollar in December 1971. The second Geneva Agreement raised the oil price by 11.9 per cent after the dollar's second devaluation in June 1973, and provided for monthly corrections according to currency fluctuations.
If the above factors are adopted, even with some modifications, they may provide an appropriate framework for more stable oil pricing. They could help set annual rates for oil price escalation, easier to predict and capable of preserving the real price value by accounting for inflation, changes in dollar value, as well as providing reasonable benefit to oil producers as compensation for rapid reserve depletion. Needless to say, such reserve depletion is mainly caused by rapidly increasing demand for oil, which serves the interests of oil consumers. On the other hand, such compensation would encourage oil producers to take the risk of financing the expansion of the oil reserve base that the world is calling for.
In applying these three factors, we should adopt 1973 as the base year and $11.65 as the price that was adjusted and accepted by the world oil community as fair and just. However, like any commodity in fast growing demand, this initial oil price should rise in real terms over time. To achieve this target we have the second factor, explained above, as a guiding indicator.
OPEC has already estimated the impact of two of the three factors -- those of inflation (factor one) and dollar value changes (factor three). The outcome was that, in the case of 2005, the nominal price of $50.84 bpd did not exceed in real terms $10.39 valued in the 1973 dollar. Likewise, a nominal average price of $65.08 over 2006-2007 did not exceed $12.40 in real terms. Thus, the real oil price, using only factors one and three, was no more than one-fifth of the nominal price.
Inserting factor two, which accounts for depletion allowance, using the 1973-adjusted real price of $11.65 per barrel as the base price, and an annual 2.5 per cent growing rate over 34 years (1974-2008) would result in $26.32 bpd as today's real price, expressed in 1973 dollars. Since the real oil price -- as estimated by OPEC using factors one and three -- was only one-fifth of the nominal price, we can conclude that today's nominal oil price should not be less than $144. This is obtained by multiplying today's real price including the depletion allowance ($26.32) by five, which represents the multiplier linking nominal and real price based on only factors one and three as already explained. That is a fact that oil market fundamentals have been trying to tell both oil producers and consumers over the past few years.
To explain the above analysis in terms of figures, this table printed has been designed to accommodate the introduction into the oil pricing mechanism of the three factors derived from the Tehran and Geneva agreements. The figures are meant only to illustrate the application of these factors, not to adopt the assumed rates that would be subject to changing circumstances.
Columns 2 and 3 are derived from the OPEC Annual Statistical Bulletin which states the actual nominal price of OPEC oil per barrel (ORB) and calculates the real price in terms of 1973 dollar value after applying factor one, which accounts for inflation, and factor three, which accounts for changes in dollar value.
Columns 4 and 5 need no further explanation, except for the growing nature of OPEC oil exports that used up OPEC shut-in productive capacity and tightened its spare capacity, which is an important determinant of price, as explained.
Column 6 is the result of multiplying nominal price (Column 2) by total OPEC exports in terms of barrels per year (Column 5).
Column 7 is obtained by escalating the real base price of $11.65 that was adjusted and accepted in 1973 using an annual rate of 2.5 per cent as a depletion allowance (factor two) over a period starting 1974 and ending at each year in the table.
Column 8 provides the nominal oil price after introducing a depletion allowance (factor two), in addition to factors one and three, which were already calculated by OPEC and resulted in Column 3. Column 8 is obtained by multiplying Column 7 by a multiplier obtained by dividing Column 3 by Column 2. As was shown, the product of this division in the last three years (2005-2007) proved that the real price of oil is equal to one fifth of the nominal price based on only two factors (factors one and three).
Column 9 is obtained by multiplying Column 8 by Column 5, providing the total nominal revenues based on the application of the three factors. Based on the above analysis, Column 9 represents what OPEC countries should get as a share of oil rent, most of which is captured by oil consuming governments and represents more than 70 per cent of the ultimate consumer price, especially in the European Union. As explained, oil producers will not be only rewarded for their fast depleting reserves but also encouraged to take the risk of financing wildcat exploration and the development of oil fields.
If these notions are accepted as a basis for discussing the problem of price volatility, then Column 10 would show how much losses were incurred by OPEC which is always blamed for price hikes no matter the real causes may be: speculation, geopolitical tension, and/or shortage of expansive investment that is a shared responsibility of producers and consumers.
* The writer is former senior undersecretary at the Egyptian Ministry of Petroleum.