Hugo Chavez Makes His Move

Hugo Chavez is setting the stage for the next chapter in world oil history. In a Monday night interview with the BBC, he indicated that he wants Venezuela to take the lead in the OPEC cartel. Chavez is planning to propose that OPEC members increase their long-term oil target price to $50 per barrel. At this price, a portion of Venezuela's Orinoco Tar Sands become economically viable, and Venezuela can officially increase its proven reserves to 312 billion barrels -- 50 billion barrels more than Saudi Arabia.

A brief history
OPEC (Organization of the Petroleum Exporting Countries) was formed in 1960 to "secure fair and stable prices for petroleum producers." Producing nations view OPEC's role as stabilizing prices in what has historically been a boom-and-bust industry. Consuming nations often view OPEC as "price fixers," rigging the market to artificially inflate prices.

Whatever its stated mission, OPEC has not been very successful in managing oil prices. In the 1990s, oil was cheap. OPEC just couldn't seem to get along. Venezuela would routinely exceed its OPEC production quotas, keeping prices down. In 1998, with oil near $10 a barrel, Hugo Chavez was elected president of Venezuela. That was the turning point.

President Chavez cut Venezuelan oil production down to the OPEC quota. He made a concerted effort to unify the cartel, which had been fragmented and contentious for nearly two decades. By 2000, his strategy was working. Oil prices had risen to $30 a barrel, and oil revenues to OPEC nations were once again on the rise.

Each OPEC member state reports "proven oil reserves" (total oil that can be produced at prevailing market prices). Production quotas for each country are established based on these reserves, creating the incentive for the aforementioned cheating. Currently, Saudi Arabia has the largest reserves in OPEC, at 262 billion barrels, with Venezuela in sixth place at 79 billion barrels.

Hugo plays hardball
Because production quotas are determined by proven oil reserves, and reserves are a function of market price, Venezuela has a lot to gain if OPEC recognizes $50 per barrel as the long-term price of oil. The country's Orinoco tar sands deposit is an ultra-heavy oil formation, not unlike Canada's oil sands. Including all of Orinoco, the U.S. Department of Energy estimates Venezuelan reserves at 1.3 trillion barrels -- more than all other OPEC nations combined. Venezuela claims that at $50 per barrel, a portion of the Orinoco tar sands becomes commercially viable, enough to bring the country's proven reserves up to 312 billion barrels.

The other members of OPEC are unlikely to welcome this development, but it will not be easy for them to simply reject the proposal. In 2004, OPEC nations were all essentially pumping at full capacity. Furthermore, OPEC member Indonesia has become a net oil importer and is considering dropping out of the cartel.

OPEC also must be looking at the production increases in several non-member states, worrying that its control over global oil markets may diminish if its member nations do not increase their reserves. After the fall of the Soviet Union, Russian oil production plummeted to 6 Mbpd (million barrels per day). Over the past seven years, however, there has been a massive investment in Russian oil production, which boosted output to 9.5 Mbpd -- making Russia the world's leading producer.

In Canada, meanwhile, high oil prices have led to massive investments in Alberta's Oil Sands, and huge profits for producers like SuncorEnergy (NYSE: SU  ) . A large portion of this ultra-heavy oil deposit is now included in Canada's oil reserves of 180 billion barrels, which places Canada second only to Saudi Arabia in proven reserves. Furthermore, investments in the oil sands will increase Canadian output from a current level of 2.6 Mbpd to 3.9 Mbpd by 2015.

Hugo opens Pandora's box
Given the possibly weakening position of OPEC, perhaps President Chavez believes he has the cartel over a barrel, and that now is the time to make his move. Whatever his thinking, it will be interesting to see how the cartel responds, and how this drama plays out in the world's oil markets.

If the cartel agrees to a significant increase in Venezuelan reserves, it will not immediately drive oil prices lower. Venezuela will need several years to increase production. Chavez may also live to regret driving away foreign investment with his strong-arm tactics. ExxonMobil (NYSE: XOM  ) and the Italian oil firm Eni (NYSE: E  ) have both pulled out of the country because of unfavorable terms. However, given current oil prices and Venezuela's reserves, 17 companies have signed a deal with the government-owned PDVSA (Petroleos de Venezuela SA), including the Spanish oil firm Repsol (NYSE: REP  ) and Royal Dutch Shell (NYSE: RDS-A  ) .

A more interesting scenario will arise if OPEC refuses to recognize an increase in Venezuela's reserves. Will Chavez return to the country's past practice of violating production quotas? Despite playing the dutiful OPEC member to date, Chavez might find the power available with increased production is likely too great a temptation for him to resist. He has been using oil revenues to build his power and influence, not only in Venezuela, but in all of Latin America and the Caribbean. He wants to continue this campaign and extend his influence to the entire developing world.

In either scenario, the danger for OPEC is that member nations will begin a race to the bottom, increasing production to maximize profits while prices are high. In the 1980s, most OPEC nations mysteriously increased their reserves by as much as 100%, just to increase production. Could the same thing happen again? Or will they skip that step and violate their own production quotas? Considering that many are already producing at maximum capacity, are OPEC nations capable of production increases? OPEC claims its members will increase production from the current level of 32 Mbpd to 38 Mbpd by 2010.

The next chapter
Will the current boom go bust? Will world consumption keep climbing in lockstep with production, leading to a stable but high oil price? We can only wait and see, but history would suggest that the boom will eventually end. For investors in the oil patch, keeping an eye on how this issue develops may just be the key to taking profits before the "bust" part of the cycle sets in.

For more petro-Foolishness:

• Drilling for Inspiration
• Harvest of Sorrows
• Searching for an Energy Revolution

Fool contributor Robert Aronen owns no shares of any company mentioned. Feel free to share your comments with him at robertaronen@yahoo.com. He thinks the "bust" part of the oil cycle will begin around 2015, but he also thought California real estate would tank in 2002. The Motley Fool has a disclosure policy.