A.G. EDWARDS & SONS, INC.
One North Jefferson, St. Louis, Missouri
314-955-3050
(March 23, 2000) ENERGY COMPLEX: Although the market believes OPEC will boost production at the March 27th meeting, one of the critical points will be allocation of new production quotas. The cartel, excluding Iraq, has about 5.5 mbpd of excess capacity above February output. However, 54% of that excess resides in Saudi Arabia. The chart shows the breakdown.
This chart shows the percentage of excess capacity. We include Iraq in the chart, but assume they have no spare capacity. As the chart shows, Kuwait, the UAE and Saudi Arabia control 76% of the cartel's available capacity. This makes quota allocation very difficult.
From an economic efficiency standpoint, the level of excess capacity should determine allocation. Why? Assuming the Law of Diminishing Returns, we can assume that as production nears capacity, costs will rise. Therefore, the production costs in a low excess capacity country will tend to rise more than it would in a high capacity nation. Following this logic, a 1.5-mbpd increase by OPEC would give Saudi Arabia 810 kbpd of new production quota, while Libya would receive a mere 30-kpbd increase. Clearly, the low capacity states will oppose such a plan.
The other possibility would be to increase an equal amount among the nations with extra capacity. Thus, an increase of 166 kbpd for each member would be allocated. Unfortunately, this is more production then Libya can meet, and nearly exhausts the capacity of Venezuela, Indonesia and Nigeria.
Thus, the small production states have tended to oppose any increase in output, preferring the current low production/high price regime. Since they either can't increase production, or the extra output will tend to be higher cost oil, they want to discourage new production, which they see benefitting the high production countries. The large capacity states, which also rely heavily on U.S. military protection, seem to favor an increase.
One obvious solution would be revenue sharing. Saudi Arabia would be given the bulk of the increase in quota, but rebate part of the increased revenue to the lower producing states. This is how the cartel avoided a production increase from Venezuela when they experience mudslides last year. Several Gulf States gave "charity" to Venezuela in lieu of more production.
The most likely outcome will be less output than the 1.5 mbpd above current production levels that most analysts suggest is needed by the market. We expect an increase of 1.5 mbpd above current quota, which will be an increase of only 0.5 mbpd above February production. We also expect OPEC to reconvene in June and raise output again if prices remain above $27 per barrel. However, without revenue sharing, tensions at these meetings will remain high.
We are long October crude oil from 24.95, risking to 24.00 with an objective of 29.00.
Bill O'Grady