For much of its more than 50 year history, OPEC has been a dominant force in the oil market. By setting production quotas and regulating output among its member states, OPEC has been able to manipulate oil prices in keeping with the political and economic interests of its members.
However, over the next decade, OPEC could become irrelevant in the world oil market, or even fall apart. The recent high oil price climate has reduced global demand growth to negligible levels, while the non-OPEC oil supply is growing faster than it has in years. These trends will expose the growing inability of OPEC members to cooperate with each other, and could even lead to the cartel's demise.
The decline of OPEC
During the 1970s, the ever-growing thirst for oil from the U.S. and other developed countries gave OPEC significant power to set prices. By 1973, OPEC members supplied over half of the world's oil ! The cartel used this leverage to great effect in that year to make a political statement about Western support for Israel, driving up oil prices fourfold through an embargo and general production cuts .
U.S. dependence on OPEC declined in the 1980s and 1990s, due to fuel efficiency initiatives and growth in the non-OPEC oil supply. Within the last decade, surging demand from developing countries like China boosted oil demand again, leading to higher prices without any action by OPEC.
However, the ongoing period of high oil prices has led to sustained declines in U.S. petroleum consumption. Many individuals and businesses are jumping on opportunities to convert from oil to cheaper (and cleaner) natural gas, while vehicle fuel efficiency is rapidly improving. As a result, U.S. net oil imports have fallen by more than 50% since 2005!
Even in developing markets like China, demand growth has slowed dramatically . At the same time, non-OPEC oil production has started growing again. The IEA expects non-OPEC supply to increase by 1.3 million barrels per day this year, and by an additional 1.8 million bpd next year . (This is significantly more than the expected level of global oil demand growth.)
The end of cooperation
Up until now, the decline in demand for OPEC oil has not had much of an impact on prices. For much of the past decade, OPEC spare capacity has been at historic lows . Additionally, increased non-OPEC production has been offset to some extent by supply interruptions caused by political unrest in countries like Libya.
This lack of spare capacity and periodic supply interruptions in various OPEC member states has kept supply and demand tightly balanced. However, it's also masked a decline in the ability of OPEC members to cooperate with each other. In fact, while OPEC has maintained a nominal production quota in recent years, it has not set targets for individual countries for several years !
Some of the greatest tension has been between Iran and Saudi Arabia. In mid-2008, as global oil prices were skyrocketing toward $150, Iran criticized Saudi Arabia for boosting production to try to bring prices down . More recently, Iranian leaders blamed Saudi Arabia, Kuwait, and the United Arab Emirates for enabling Western oil sanctions against Iran by boosting their output to compensate for the decline in Iran's exports .
Indeed, Saudi Arabia has shown a strong tendency to act unilaterally in recent years. Its position as by far the top producer within OPEC and its significant spare capacity have made it easy for Saudi Arabia to go its own way. However, the changing dynamics of the oil market may require more cooperation in the future -- but this cooperation will be hard to engineer.
Today, OPEC spare capacity stands at nearly 5 million barrels per day. More than half of that spare capacity is attributable to Saudi Arabia. The vast majority of the remainder is in countries like Libya, Iran, Iraq, and Nigeria, where production is constrained by political instability (or sanctions, in Iran's case) -- not any deliberate decision to cut output .
However, Iraqi production has been steadily increasing, and could start to rival Saudi Arabia's output within the next decade. Iran's recent deal with the global superpowers to roll back sanctions could lead to resurgent production there as well. Libya is even more volatile, but political leaders think production could jump by 1 million bpd or more in a very short period of time .
Whereas recently, Saudi Arabia has been pumping around 10 million bpd and the rest of OPEC has been producing near capacity, OPEC could have substantial spare capacity in 5-10 years. This will create a massive coordination problem among its members.
On the one hand, most OPEC members rely heavily on oil revenue to support expansive -- and expensive -- social programs . That means that each individual country has a strong incentive to pump as much oil as it can. On the other hand, if the global oil supply continues to outgrow demand, OPEC's members will need to cut back on production to keep prices up.
At present, Saudi Arabia is the only country that is voluntarily restraining its production in any significant way. However, it will eventually be unable or unwilling to continue cutting its own production without reciprocal cuts by other OPEC members.
Even if OPEC managed to set production quotas for each country, the urge to cheat would be overwhelming. For each country, producing an extra 100,000 or 200,000 bpd seems fairly innocuous; it provides extra revenue to support government services and is not enough to disrupt the market. However, if all 12 OPEC members do that simultaneously, suddenly there could be a glut of oil.
The end of OPEC?
Tensions have run high among OPEC members in recent years, despite historically high oil prices and a tight supply demand balance. Even when it should have been easy to agree, it has been hard to forge consensus.
Over the next 5-10 years, the rapid growth in non-OPEC oil supply is likely to fully offset global demand growth. If at the same time production rebounds in Iraq, Iran, and Libya, other cartel members would need to cut production significantly to avoid an oil glut. OPEC's members have shown no ability to take coordinated action in this way in the past decade. Put simply, the cartel appears to be so fragile today that any attempt to limit production through strict country quotas could cause it to fall apart entirely.
No matter what happens, Americans shouldn't expect gas prices to fall back to $1.50 again. Much of our oil supply today is only available because prices are relatively high -- if prices fall too much, many unconventional oil projects could become uneconomical, bringing supply and demand back into balance. However, OPEC's ability to keep oil prices above $100/barrel could soon be a thing of the past.
Our top pick for profiting from the oil boom
Imagine a company that rents a very specific and valuable piece of machinery for $41,000... per hour (that's almost as much as the average American makes in a year!). And Warren Buffett is so confident in this company's can't-live-without-it business model, he just loaded up on 8.8 million shares. An exclusive, Motley Fool special free report reveals the company we're calling OPEC's Worst Nightmare. Just click HERE to uncover the name of this industry-leading stock... and join Buffett in his quest for a veritable LANDSLIDE of profits!