The OPEC Multiplier

Bijan Mossavar-Rahmani is a doctoral candidate at Harvard studying political economy and government and a former delegate to the OPEC Ministerial Conferences. His most recent book, OPEC, and The World Oil Outlook; Rebound of the Exporters? was released by the Economist Intelligence Unit last week.

Don't bury OPEC yet.

Admittedly, at first glance, the immediate prospects for OPEC hardly look promising. Its oil production remains at the lowest level since the mid 1960s. Supply availability exceeds demand by a wide margin. Official prices were forced down last week for the first time in OPEC's 23-year history. Additional price cuts seem almost imminent. OPEC's internal problems have been accentuated by the fact that two of its most important members, Iran and Iraq, are still at war.

OPEC has never appeared more shaken, more divided. But it is premature to conclude, as many observers are now doing, that OPEC's current plight will somehow become a permanent fixture of the world oil scene. Some of these observers are making serious errors of judgment and analysis. Others are seeking to validate their own research by generating results that fall within the ballpark of prevailing opinion. Still others are drawing long-term conclusions from short-term, cyclical market conditions. All are allowing the wish to father the thought.

For the process that has sharply reduced OPEC oil production since 1979 can also cause it to rise quickly again-leading to a tight world market in which prices can once again jump substantially. The driving force behind this process is a phenomenon best described as the "OPEC multiplier."

OPEC is the residual or marginal source of supply to the world energy regime. It is the only after indigenous energy resources (i.e., hydro, coal, nuclear, oil, and natural gas) are produced at capacity levels that countries turn to foreign suppliers to meet additional needs. Most countries first turn to such non-OPEC suppliers as Mexico, Norway, and even the Soviet Union, either because of consideration relating to price or security of supply or both. Only then do buyers finally turn to OPEC as the supplier of last resort. Conversely as oil demand begins to decline, OPEC oil is the first to be dropped. In short, a small increase in world energy demand results in a disproportionately large percentage increase demand for OPEC oil. And a small decrease in world energy demand results in a disproportionately large percentage decrease in demand for OPEC oil. This is the OPEC multiplier at work.

A few numbers illustrate this phenomenon. OPEC currently accounts for just over 10 percent of world energy consumption. If, during a period of declining energy demand (say, in part due to recession). OPEC oil were treated like any other fuel, then a 5 percent decline in world energy consumption would result in a five percent decline in OPEC production. But, if all the decline is borne by OPEC as the residual supplier, then a 5 percent decline in the total leads to a 50 percent drop in OPEC oil. The actual drop in OPEC oil production since 1979 is somewhat more pronounced than this example would suggest (about 55 percent versus about 3 percent for total world energy consumption) because non-OPEC oil production has been climbing during this period.

The significance of this multiplier effect is that it not only works, but works in reverse as well. Thus even a small percentage increase in total energy consumption could lead to an explosion in demand for OPEC oil-one far greater than most analysts consider possible today. If so, the market would be simply repeating what was a pattern of the 1970s.

In 1976, for example, the global recession had basically run its course and real oil prices were falling. The world economy and world energy demand grew by just over 5 percent each. The impact on OPEC oil was much more pronounced; after a 12 percent drop in 1975, OPEC oil surged 13 percent in 1976.

To repeat, OPEC is the residual supplier of energy to the rest of the world. As such, it is the supply source most profoundly affected or multiplied by swings, downward or upward, in world energy markets. If, as now expected, world economic growth picks up this year, the resulting recovery in demand for OPEC oil could be disproportionately large. Indeed, falling oil prices will speed economic recovery while undercutting investments in non-OPEC energy supplies and a wide range of conservation efforts.

The same forces that drove down demand for OPEC oil will drive it back up again-perhaps in as short a time. By as early as 1986, world demand for OPEC oil could climb from its current depressed level of less than 15 million barrels daily to within its physical production capacity of about 30 million barrels daily. It would then take only a small disruption in supplies, say in the winter of 1986 or-equally important-an expectation of impending shortages, to trigger a new round of panic buying and stock-piling by worried buyers. This would kick up oil prices, much as have occurred in the 1973-74 and again in the 1979-80 oil crises. The world price of oil could double within six months of the disruption.

There is, of course, nothing magical about the winter of 1986; the writer is not predicting-no one can predict-that an oil supply disruption will occur that year. An oil supply disruption could occur in 1985 or in 1987. What is important is that the growing volatility of the Persian Gulf region and the consequently higher probability of disruption almost insure that an oil supply cut-off of sufficient magnitude and duration will occur sometime in the 1980's. The later the disruption occurs, the greater its impact on oil prices, since the world oil market will become increasingly tight with each passing year under any reasonable set of assumption about future supply and demand patterns.

The oil problem then remains the same. It is the threat of political upheaval that translates into supply interruption and economic chaos. The current situation in the world oil market, while creating--at least temporarily-substantial spare capacity, also increases the possibility of turmoil in the Persian Gulf region. As the real oil revenues of the OPEC countries continue to plunge with reduced oil production and deteriorating world oil prices, spending will have to be cut back.

The dramatic decline in OPEC's surpluses will jeopardize development efforts in these countries, force cancellation of projects (thus alienating special interest groups), reduce the availability of imported goods, increase unemployment, and in general create social, economic and political tensions of the kind that preceded and indeed contributed to the revolution in Iran. Such tensions not only threaten the domestic stability of these countries, creating conditions for upheavals that could interrupt oil supplies, but could even turn one oil exporting country against another, as has been the case in the Iran-Iraq war. At the very least, sharply falling oil revenues today and in the next few years breed powerful incentives for OPEC, even without another disruption, to increase oil prices when the market tighten. The OPEC multiplier is the mechanism that will make it possible.

Ironically, by encouraging complacency about the future availability and price of oil; those who now pronounce the oil crisis and by extension OPEC dead, may help trigger the very out come they so casually dismiss.