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An Inconvenient Truth about OPEC

DALLAS – The three major organizations that forecast long-term oil demand and supply – the International Energy Agency (IEA), the Organization of Petroleum Exporting Countries (OPEC), and the United States Energy Information Administration (EIA) – along with oil companies and consulting firms, believe that OPEC will reconcile predicted global demand and non-OPEC supply. But they are wrong: OPEC output will not meet such projections, because they are based on flawed and outdated forecasting models.

In forecasts that carry forward to the 2030’s, the three organizations share the view that world energy demand will increase, that developing countries will account for most of the increase, and that fossil fuel will remain dominant. They also agree that dependence on oil from OPEC members will increase as non-OPEC oil resources dwindle and become more expensive to extract. But a major flaw in modeling world oil markets makes these forecasts as unrealistic as a projection that humans will land on Mars tomorrow.

Current forecasting models project world oil demand based on variables such as economic growth (or income), oil prices, the price of oil substitutes, and past demand. They also project non-OPEC output using variables such as oil prices, production costs, and past supply. But, after forecasting world demand and non-OPEC supply, these models simply assume that OPEC will supply the rest – without taking into account OPEC behavior or considering that OPEC members might not be willing or able to meet the “residual” demand. For this reason, these models estimate what is known as the “call on OPEC,” the difference between estimated world demand and estimated non-OPEC supply.

The idea to model the “call on OPEC” gained ground after the October oil embargo of 1973, a time when few economists were familiar with the oil market. The magnitude of the energy crisis attracted economists from a wide array of specialties. To diagnose the problem, they opened their tool kit and used what was available: if the supply-and-demand model did not work, then the monopoly model would.

Economists, politicians, and the media thus found the term “cartel” to be highly convenient. According to the monopoly model, the cartel would always supply the difference between total demand and the output supplied by non-cartel members. Although the situation has changed drastically since the early 1970’s, and the cartel model has been proved wrong and harmful, it is still used today.

According to the model’s main assumption –, OPEC will always produce the difference between world demand and non-OPEC production.  But OPEC ran out of spare capacity between 2005 and early 2008 and was not able to increase production as demand increased.  Prices skyrocketed and exceeded all earlier forecasts

It is nearly impossible for OPEC members to produce the difference between estimated world demand and non-OPEC supply. For example, in its recent forecast, the EIA’s base-case scenario is that, by 2035, OPEC will add about 11 million barrels of oil a day (mb/d) to its 2010 output. Is this possible when production is declining at a rate of at least 3%?

Let’s check the math: at a 3% rate of decline, OPEC needs to add an additional 17 mb/d by 2035 just to maintain 2010 production. If the EIA forecasts OPEC production to increase by about 11 mb/d, OPEC needs to add about 28 mb/d in the next 25 years, a feat that it has never accomplished – indeed, current production capacity is similar to that of the mid-1970’s.
The situation gets worse if non-OPEC production declines below forecasts; oil prices must increase substantially in order to ration demand and reconcile it with lower supply.

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Five factors prevent the projected “call on OPEC” from being met:

  • A shift in investment from oil to natural gas in oil-producing countries;
  • Rising domestic oil consumption – and thus lower oil exports – by OPEC countries;
  • The reaction of oil-producing countries to the rhetoric of energy independence in consuming countries, which has led to their developing energy-intensive industries that reduce oil and gas exports. Producing countries believe that if they cannot export oil to consuming nations, they can at least export the oil embedded in energy intensive products such as petrochemicals;
  • Lack of “investment absorptive capacity” at high oil prices (the local economy’s ability to absorb investment), which makes OPEC members unwilling to produce more oil. If OPEC nations cannot invest the additional oil revenues, then they might prefer to keep oil in the ground;
  • Most importantly, demand for new production to compensate for 3% rates of decline in OPEC’s oil fields is so huge that it cannot be met in less than 20-25 years;
  • The inability to meet the expected “call on OPEC” and the higher prices resulting from shortages will create excellent opportunities for international oil companies, independent producers, and private-equity investors. It will also create an opportunity for other energy sources to fill the gap that OPEC members were expected to fill but did not.

Indeed, given the expected growth in energy demand in the next two decades, and the possible – even likely – shortfall in OPEC supply relative to the projected “call on OPEC,” the term “alternative energy” will lose its meaning. The only “alternative” to harnessing all feasible energy sources will be a slow-growth world of permanent shortages and increasing misery.

Anas F. Alhajji is Chief Economist at NGP Energy Capital Management.

Copyright: Project Syndicate, 2010.

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