THE OIL MARKET OUTLOOK IN 1986: CONTINUED VOLATILITY, GREATER UNCERTAINTIES

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• Document Page Count: 28
• Document Creation Date: December 22, 2016
• Document Release Date: March 18, 2011
• Sequence Number: 1
• Publication Date: February 1, 1986
• Content Type: REPORT

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Directorate of
Intelligence
Greater Uncertainties
The Oil Market Outlook
in 1986: Continued Volatility,
G186-10011
February 1986
copy 320
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~tEf Directorate of Secret
Intelligence
The Oil Market Outlook
in 1986: Continued Volatility,
Greater Uncertainties
This paper was prepared by
Office of Global Issues, with
queries are welcome and may be directed to the
Chief, Strategic Resources Division, OGI,
Secret
6186-100/1
February 1986
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The Oil Market Outlook
in 1986: Continued Volatility,
Greater Uncertainties
Key Judgments The international oil market is teetering on the edge of a price collapse.
Information available The mid-January decline in spot prices and the futures market suggests
a.s ot 17 Januari 1986 that oil prices could fall well below $20 per barrel over the next several
vi (is aced in this report.
months. We believe there is a 50-percent probability that prices will
average below $20 per barrel in 1986, in contrast with the consensus in the
oil industry that expects oil prices to average in the $22- to $24-per-barrel
range. The major factor propelling the market downward is the Saudi move
to increase its market share rather than defend the price level. At this time,
no other producer seems willing to cut production voluntarily to make room
for higher Saudi output. Moreover, even if producers get through the next
few weeks without further price declines, they will face another key test
over the next three months when seasonal factors cut oil demand by about
3 million barrels per day (b/d) from current levels.
OPEC's decision announced in mid-December to defend its "fair share" of
the oil market is intended to pressure non-OPEC producers and oil
companies to share the burden of maintaining prices. Barring a decline in
prices to well below $20 per barrel, however, we believe non-OPEC
producers are unlikely to bow to OPEC pressure and reduce output
significantly. One problem is that non-OPEC producers are a large group
with disparate interests and no formal mechanism for communication or
coordination. Under these circumstances, we believe the burden for
stabilizing the market will ultimately fall on the OPEC group. We believe
OPEC's ability to reach agreement, however, is dissipating because of
widely varying needs and policy objectives.
Demand prospects also will provide no relief. We estimate that non-
Communist oil consumption will hold steady and non-OPEC production
will rise by about 400,000 b/d in 1986. Under these conditions, demand for
OPEC oil, including natural gas liquids, will average 17.3 million b/d for
1986, about the same as last year and almost 2 million b/d below current
production levels. If OPEC maintains production at or near current levels,
prices will continue to decline.
How far oil prices fall is difficult to predict and will depend primarily on
how aggressively OPEC follows through on its decision to defend market
share:
? Price erosion. We believe prospects of greater financial pressures for
many OPEC members could encourage the group to adopt a production
Secret
Secret
GI 86-10011
February 1986
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target of about 18 million b/d or less. Even under this scenario, we
believe prices this year could still average as little as $20, compared with
last year's average price of about $27 per barrel.
? Price collapse. If OPEC attempts to maintain oil production near its
current level of 19 million b/d, however, oil prices would have to fall
sharply. Under this scenario, oil prices would fall perhaps to as low as
$15 per barrel. Because oil demand is relatively unresponsive to price
declines in the short term, declining revenues would increase pressure on
most producers to raise output to maintain revenues.
Market psychology and uncertainties about producer actions is likely to
cause wide price fluctuations over the near term. Moreover, a move toward
market-related pricing and competitive pressures will likely cause substan-
tial price volatility throughout the year.
The prospect of lower oil prices is good news for the global economy, but a
sharp price reduction would have a strong and adverse impact on oil-
exporting debtor countries. Erosion of oil prices to below $20 per barrel, for
example, would push the financial needs of the heavily indebted oil-
exporting countries-such as Mexico, Nigeria, and Venezuela-beyond
the resources of the Baker plan unless additional strong austerity measures
were taken. A decline could also cause some countries to try to follow the
examples of Peru and Nigeria to limit debt service to a fixed percentage of
export earnings. The impact of reduced revenues on internal political
stability even in countries like Saudi Arabia could also be significant if the
inevitable adjustment to greater austerity is not carefully managed. For the
longer term, lower prices would tend to slow oil and gas supply develop-
ment, dampen conservation and substitution efforts, and hasten a return to
heavy dependence on Persian Gulf supplies.
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Key Judgments
Introduction
Recent Market Developments
Consumption Down
Destocking Continues
Supply Side
Outlook for 1986
2
Consumption Projection
2
Inventory Behavior
5
Non-OPEC Supplies
5
Demand for OPEC Oil
5
New OPEC Strategy
7
Non-OPEC Reaction
7
Industrialized Countries
7
Third World Producers
9
The USSR
9
The Saudi Role
12
Other OPEC Producers
12
Price Outlook
Lower Prices Ahead
13
Price Erosion
13
Price Collapse
13
Increased Pressure in the Spring
15
Implications
16
16
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Price Volatility
This paper addresses expected average annual trends
in oil prices over the next year. Market factors and
psychology, however, are likely to cause wide fluctua-
tions in prices during 1986. Uncertainties over OPEC
actions will fuel volatility over the coming weeks,
especially in the speculator-dominated market. These
changes are impossible to predict. Seasonal demand
trends, inventory behavior, and the changing nature
of oil marketing and pricing will also contribute to
short-term market fluctuations. For example, in mid-
January the spot prices of similar quality crudes
traded at a price differential of more than $6 per
barrel. At one point, spot North Sea Brent traded for
$20.50 per barrel and at $19 per barrel on the futures
market while Saudi Arab Light sold at $27, primari-
ly because little Saudi crude was being sold on the
spot market. Nevertheless, spot prices for key crudes,
such as Brent, remain a valid leading indicator of oil
price trends.
Abandonment of official prices and the trend toward
using market-related prices have exacerbated price
movements. According to a recent study, oil produc-
ers are now depending heavily on innovative sales
techniques to maintain market share. The study
estimates that approximately 90 percent of OPEC
sales are made at market-related prices. Only a small
percentage of sales are transacted on the spot market,
although many term arrangements are negotiated at
spot-related prices. The following is a list of various
pricing techniques:
? Official or contract prices. Oil purchased on con-
tract is based on predetermined or government-
established prices.
? Spot prices. Market-determined prices for prompt
delivery of a single cargo are often determined at
the time of transaction. Many short-term contracts
are now based on spot-related prices.
? Netback prices. Crude prices based on the market
value of individual products are derived from the
crude minus transportation and refining costs.
? Equity price. The cost of oil to a producing compa-
ny for that portion of output owned by that compa-
ny as a result of its equity holdings in an oilfield.
This price is composed of the royalty and tax
payments to producer governments and the produc-
tion costs.
? Futures prices. Prices based on contracts traded on
official futures or commodity markets. Contracts
are traded for specific grades and quantities of oil
for various future months and represent specula-
tors' and hedgers' opinions about likely price
trends. Although future prices are often a leading
indicator, little oil actually changes hands-most
trades are merely paper transactions. Last year
only about 400,000 bid of crude oil changed hands,
roughly 4 Percent of total future crude oil sales.
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The Oil Market Outlook
in 1986: Continued Volatility,
Greater Uncertainties
The international oil market is in disarray. The sharp
fall in spot and futures oil prices in January suggests
that downward pressure and substantial volatility will
intensify in the months ahead. Prices for some North
Sea and US crudes plunged to below $20 per barrel in
mid-January. Futures prices, which are heavily influ-
enced by speculators, fell even further. Spot prices for
OPEC crudes, however, remained about $25 per
barrel. Taken together, we estimate that average oil
prices declined to as low as $23 per barrel in January,
down from the 1985 average of about $27. The resolve
that OPEC producers show in maintaining increased
market share will play a key role in determining oil
price trends, especially in the critical next few
months.
Consumption Down
Following a I-million-barrel-per-day (b/d) rise in
1984, non-Communist oil consumption dropped by
about 1 percent last year to 44.9 million b/d, despite a
2- to 3-percent rise in economic activity, according to
our estimates. Conservation gains, substitution away
from oil, and a slowdown in economic growth in the
industrialized countries caused a roughly 500,000-b/d
fall in OECD oil consumption, with the largest de-
clines occurring in fuel oil use (figure 1). On the basis
of fragmentary data, we estimate that consumption in
LDCs rose by about 200,000 b/d last year.
Temporary factors probably caused the slight growth
in consumption in the fourth quarter of 1985. Prelimi-
nary data indicate that oil consumption in that quar-
ter rose about 1 percent above year-earlier levels, the
first quarterly increase in more than a year. In our
judgment, this reflected stronger economic growth in
the United States and colder-than-normal weather in
Western Europe. It also reflected lower oil prices in
Western Europe and Japan resulting from a decline in
the value of the dollar and a subsequent decrease in
the cost of oil imports in local currency of about 20 to
25 percent during last year.
Destocking Continues
Industry efforts to reduce inventories continued last
year in response to high real interest rates and
expectations of falling prices, placing additional
downward pressure on the market. We estimate that
non-Communist oil stocks on land at yearend stood at
3.8 billion barrels about 200 million barrels below
year-earlier levels. Some companies believe oil stocks
were near minimum operating levels at the end of the
third quarter; one major oil company experienced
some minor spot shortages last fall. Indeed, low
inventory levels caused companies to increase liftings
from OPEC countries in the fourth quarter to meet
high seasonal winter consumption. Some companies
believe the sharp rise in production in the fourth
quarter, however, may have overshot demand and
caused an unexpected counterseasonal stock build in
the fourth quarter.
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Supply Side
Non-OPEC supplies, including net Communist ex-
ports, rose by about 400,000 b/d in 1985, the smallest
increase in four years and only about half as much as
many forecasters had anticipated. A roughly 300,000-
b/d drop in net Communist exports caused by a
similar decline in Soviet production was mainly re- 25X1
sponsible for the slowdown in the growth of non-
OPEC supply. Nevertheless, production continued to
grow in numerous countries, including the United
Kingdom, India, Norway, Australia, Canada, Brazil,
Egypt, and Oman. Non-OPEC output now represents
more than 60 percent of total supply, compared to
only about 40 percent in 1973 before the first oil price
Following a summer of production restraint, OPEC
oil output (including about 1.1 million b/d of natural
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Figure 1
OECD Oil Consumption Trends, 1983-85
-10 I II Ill IV 1 11 III IV 1 II Ill IV
1983 84 85
Motor gasoline
Distillate fuel oil
Heavy fuel oil
Total
-20
gas liquids) in the fourth quarter rose to 19 million
b/d, up 3 million b/d from third-quarter levels. For
the year, OPEC production averaged 17.3 million
b/d. The Saudi decision to abandon its role as swing
supplier and move aggressively to increase its exports
propelled Saudi crude output to more than 4 million
b/d (excluding natural gas liquids) in the fourth
quarter. Riyadh boosted sales by selling oil at a
discount using new pricing arrangements-netback
deals-that link crude prices to spot oil product
prices. This policy change marked an end to the Saudi
defense of the official OPEC price structure (figure 2).
Most oil producers have now abandoned official sales
prices in favor of spot-related prices (figure 3).
Consumption Projection
The consumption outlook for 1986 offers no relief for
producers. We believe non-Communist oil consump-
tion will approximate 44.9 million b/d in 1986-the
same as last year-with efficiency improvements off-
setting the effects of lower real prices and modest
economic growth (table 1). We believe lower oil
consumption in the developed countries will offset an
expected small increase in LDC oil use. Oil consump-
tion in the OECD is expected to decline by roughly
200,000 b/d, mainly reflecting lower oil use in West-
ern Europe. We expect sharply lower fuel oil sales in
the United Kingdom during first-half 1986 compared
to the same period in 1985, reflecting the end of the
coal miner's strike in March 1985 (figures 4 and 5).
Under our forecast, consumption during the peak
winter quarters will approximate 46 million b/d,
compared with low seasonal requirements of 43 mil-
lion b/d during the spring and summer quarters
(figure 6). Our forecast is in line with industry
projections.
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production Ceiling IX
F million b/d
output '4 million h/d
It
(III ( ceiling drops to I7.>
million h/d
Suudi output 6.6 million h/d
I ill Of'[ ( price Cut - down
$, per harrcl
( Ching ,I-ad 17
million h/d
Saudi output 4.7 million h/d
OI'I ( sets 1983 ceiling IXS
million b/d
Saudi unlpul ;.3 million h/d
ODIC lowers pricc SI to
$'_X per hurrcl_
Saudi output 3./ million b/d
OI'lC Coiling rcduccd 10 16
million h/d
Saudis illiciallc agree to he
swing pnrdueer
Output 4.2 million h/d
Figure 2
Evolving Saudi Oil Policy
Million h/(1
10
(III ( announces will delend
"lair shore" of mar kcl_ S;iudi
output , IIIi Ilion 1, /d
Saudi output up to 4 million h/d
OP [C meeting crlds in disarrat
Saudls ibandon swing producer
role -sign nethack deals.
Nine OP[( ministers meet in
bail; King I ahd sIai nlent
adnxmishcs DPI C for nccr-
production. Saudi output
27 million h/d
1 I 1A.._l. 1LL-
19X2 N1 \ 1) 1983 N1
._LLL I -L I I L LI I I I I I I I I _L 1 11 11--L 1
1984 0 1985 M J S C) D
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Figure 3
Oil Prices, 1985
i . I 1 I i I.1-Li . 1 1 . 1 - 1 i 1111 1lLL_L I H -t - i LL X11-1-1_L_LL
24 Jan Feb Mar Apr Ma} Jun Jul Aug Sep Oct Nov Dec
Netbach prices reprscnt the sJIuc of the pruducti obtained from refining a
tunnel of crude oil minus transportation and relining costs.
Table 1
Non-Communist Oil Demand and Supply Outlook a
I
II
Ill
IV
I
II
III
IV
Consumption
46.6
43.3
43.6
45.9
44.9
46.3
43.1
43.8
46.4
44.9
Inventory change
-2.6
0.2
-0.2
0.7
-0.6
1.1
0.2
0.3
-0.3
-0.2
Supply
44.0
43.5
43.4
46.6
44.3
45.2
43.3
44.1
46.1
44.7
OPEC
17.7
16.7
16.1
19.0
17.3
18.1
16.1
16.8
18.3
17.3
Non-OPEC a
26.3
26.8
27.3
27.6
27.0
27.1
27.2
27.3
27.8
27.4
CIA estimates excludes refinery gain.
Includes natural gas liquids.
Includes net Communist exports.
J Projected.
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On the basis of the CIA linked econometric model
and industry assessments, we estimate that non-
Communist oil demand will hold steady in 1986. Key
assumptions underlying our forecast include.-
Organization for Economic Cooperation and Devel-
opment countries will experience a 2.9-percent in-
crease in real GNP, about the same as last year.
Japanese and US growth are expected to be about 4
percent and 3 percent, respectively, while West
European growth will approximate 2.4 percent.
This outlook is consistent with the latest OECD
Secretariat assessment. Real growth in LDC coun-
tries will approximate 4 to 5 percent.
? OECD energy demand will grow by 1.2 million
barrels per day oil equivalent (b/doe) or 2 percent
above Year-earlier levels. Continued conservation
gains are expected, albeit at a slower rate. We
estimate the overall energy-to-GNP ratio fell by
about 1.5 percent in both 1984 and 1985. The
replacement of older household and industrial
equipment with more fuel-efficient equipment con-
tinues to hold down energy demand growth. Contin-
tied apparent conservation gains also reflect the
ongoing structural shift toward less energy-inten-
sive industries such as high technology and services.
We assume that the energy-to-GNP ratio will fall
by 1 percent this year as declining real oil prices
slow efficiency gains (figure 4).
In 1986, we assume that nonoil energy supplies in
OECD countries will rise by 1.4 million b/doe, com-
pared with an estimated 1.7-million-b/doe increase
recorded last year. Nuclear power and coal usage will
continue to climb, albeit at a declining rate. Nuclear
power and coal supplies will rise by 600,000 b/doe
and 400,000 b/doe, respectively (figure 5). Although
most forecasters expect fuel oil demand to remain
weak, the rate of decline will probably slow, reflect-
ing in part a smaller increase in nuclear power. F
Inventory Behavior
Surplus available production capacity, increased re-
finery flexibility, and prospects of lower oil prices will
encourage companies to minimize inventories. We
believe oil companies have some flexibility to reduce
inventories because of overbuying in fourth quarter
1985. We assume total stocks will decline by 200,000
b/d this year and most of the excess stocks added
during the fourth quarter of 1985 will be depleted by
midyear. As a result, we assume a first-quarter
drawdown of 1.1 million b/d, followed by a 200,000-
to 300,000-b/d stockbuild in the second and third
quarters, and a 300,000-b/d drawdown in the fourth
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Non-OPEC Supplies
Based on industry projections, we expect non-OPEC
supplies to increase by about 400,000 b/d in 1986
(figure 7). Production increases in several countries
will more than offset a further 100,000- to 200,000-
b/d decline in net Communist exports:
? Among the OECD countries, Norway is expected to
increase production by an additional 100,000 b/d. A
small increase is also expected from several offshore
fields in Australia.
? In Latin America, Brazil and Colombia are both
expected to register annual gains of approximately
50,000 b/d or more. 25X1
? In the Middle East and Africa, Angola is forecast to
boost production substantially. According to Em-
bassy reporting, Syrian output will increase by
50,000 b d. Oman is also likely to raise output this
year.
Demand for OPEC Oil
Given our estimates of oil consumption, inventory
behavior, and non-OPEC supplies, demand for OPEC
oil in 1986 should approximate 1985 levels, which
averaged about 17 million b/d, including 1.1 million
b/d of natural gas liquids. With the anticipated
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Figure 4
OECD: Energy and Oil Efficiency
Trends, 1973-85
i I
U 1973 7S
I I I I L J J l_L__l. I I_ L I1 ~
80 85 50 1973 75 80
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Figure 5
Substitution Erodes OECD
Oil Consumption, 1982-86
%1iIii(n h/d Oil C(IUI IIcnt
0 Total merge 0 Coal
E-1 Oil ? Ilvdro
I 1 1;ituril gas \Uclcar
seasonal decline in consumption, we estimate demand
for OPEC oil will approximate 16 million b/d in the
second quarter-3 million b/d below fourth-quarter
levels (table 2). We believe that companies inadver-
tently built inventories in the fourth quarter; there-
fore, efforts to draw down excess inventories could
reduce demand for OPEC oil before spring. This
forecast is in line with most industry estimates we
have reviewed (table 3).
Faced with Saudi Arabia's decision to increase pro-
duction and prospects of a continuing decline in
demand, OPEC has in effect announced its intention
to defend market share rather than prices. This is an
attempt to force non-OPEC producers to restrict
output. Since 1979, demand for OPEC oil has fallen
by more than 14 million b/d, or almost 50 percent,
while non-OPEC production has risen by almost 6
million b/d, or almost 30 percent (figure 8). The mid-
January period of price declines is a direct result of
OPEC's market share position. This initial round of
price pressures has focused on non-OPEC crudes, but
market forces are almost certain to transfer at least
some of the price pressures back to OPEC producers
within a few weeks. 25X1
Non-OPEC Reaction
In our judgment, non-OPEC producers will be reluc-
tant to bow to OPEC pressure and to reduce oil
production to help stabilize prices, particularly in the
early stages of a price slide. Non-OPEC producers are
a large group with disparate interests and no formal
mechanism for communication or coordination. Be-
cause of low operating costs for most fields, prices
would have to fall dramatically before operators
consider shutting in production for economic reasons.
Some oil companies estimate that only about 750,25X1
b/d of production-mostly in the United States
may be uneconomic if prices fall to the $15-to-$20
range. North Sea operat-
ing costs are below $10 per barrel. Remedial action by
oil companies-such as moving forward maintenance
schedules to temporarily lower output is a more 25X1
likely possibility but would have limited impact. In
the event prices fall well below $20 per barrel, non-
OPEC producers probably would reevaluate their
willingness to cooperate with OPEC.
25X1
Industrialized Countries. Although London could
legally invoke depletion laws to restrict oil output, the
United Kingdom is not likely to use this power. Overt
action to support prices would be politically sensitive
at home, given that Britain is also a major energy
consumer. Many government officials and private
academicians have argued that there are broad eco-
nomic benefits of lower prices. Although at times the
government has "talked up" the benefits of price
stability, generally UK energy policy has mirrored US
policy to allow market forces to determine world oil
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Figure 6
Non-Communist Oil Consumption,
Seasonal Trends, 1980-86
2u I II III I\ I II
1980 81 III IV' 1 II III IN
82
II III I\ I II III IV' I II III Ib' I if III IV
83 84 8S 86,
Figure 7
Non-OPEC Oil Production, 1980-86
Net Communist petroleum
exports (CPE),
Egypt
Norway
United Kingdom
`_.__._ I __ _ l I
U 19811 81 82 83 84 85 861,
IIKItIItC1 11AIII tI ca+ liquid.
~' Iaim:ucd_
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Table 2
1985 OPEC Production
Third
Quarter
Fourth
Quarter
1985 Average
Total OPEC
16.1
19.0
17.3
Saudi Arabia
3.1
4.9
3.9
Rest of OPIA
13.0
14.1
13.4
Algeria
I.0
1.1
1.0
Ecuador
0.3
0.3
0.3
Gabon
0.2
0.2
0.2
Indonesia
1.3
1.3
1.3
Iran
2.2
2.3
2.3
Iraq
1.5
1.7
1.4
Kuwait
1.0
1.0
I.I
I.ih' a
I.I
1.2
1.1
Nigeria
1.3
1.8
1.5
Qatar
0.3
0.3
0.3
tiAF.
1.2
1.3
1.3
VCne/UCla
1.6
1.6
1.6
Includes natural gas liquids.
Includes share of Neutral Zone production.
prices. We believe US reaction to oil market develop-
ments will play a key role in determining UK actions
if prices fall sharply. Still, a sudden, sharp decline in
oil prices could have serious negative effects on the oil
sector and the value of the pound, and the UK
Government could choose to take limited steps to
lessen price pressures. Embassy sources believe that
possible actions include:
? Public statements reaffirming the government's in-
terest in price stability.
? Moral suasion to convince the larger industry opera-
tors to cut production.
? Push forward normal summer maintenance with
tacit government approval. Last year, summer
maintenance lowered North Sea output by as much
as 400,000 b/d for several months.
? Shutting in as much as 250,000 to 300,000 b/d of
royalty production with companies "banking" the
oil for the government.
Industry trade representatives indicate Norway has no
plans to reduce oil production to prevent a fall in oil
prices, although press reports suggest that the govern-
ment might take action if prices were to fall sharply.
Although it is unlikely that real policy changes are
pending, according to recent Embassy reporting, in
the face of criticism from political opposition and
rapidly falling oil prices, the Norwegian Government
is currently evaluating its longstanding position of not
intervening in the oil market. We believe that, while
Oslo could live temporarily with lower tax revenues
resulting from a cut in production, the government
recognizes that unilateral moves to reduce output
would have little impact and could potentially affect
gas production needed to meet long-term contract
commitments. 25X1
Canada is unlikely to cut oil production. The Mul-
roney government has been fairly successful in over-
turning the negative impact on oil and energy invest-
ment of the 1980 National Energy Plan and would be
reluctant to make any policy change to reduce pro-
Third World Producers. LDCs are also unlikely to cut
oil output in the near term for various reasons, 25X1
including the drive for energy self-sufficiency and the
need for foreign exchange earnings. In our judgment,
Mexico and Egypt will not reduce production to
support OPEC. Both participated in earlier OPEC
production cutting and were hurt when OPEC mem-
bers cheated. According to Embassy sources, Cairo
may cap production in mid-1986 for a different
reason to maximize long-term oil recovery. Mexico,
however, faced with severe financial pressures, may
try to boost output to maximize foreign exchange.
Other LDCs might also boost production to protect
revenues if prices fall. Malaysia, for example, is
considering increasing its 1986 production target if
prices fall below $24 per barrel, according to Embassy
reporting. 25X1
The USSR. The Soviet Union has indicated a willing-
ness to participate in any OPEC discussion with non-
OPEC exporters, We
25X1
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Table 3
Industry Oil Market Estimates a
I II III IV
Non-Communist consumption
Firm A, Dec 1985 47.8 44.1 45.4 46.9
Firm B, Nov 1985 47.5 44.2 44.3 46.4
Firm C, Nov-1 9 8 5 47.2 43.9 44.4 46.0
Firm D, Dec 1985 47.5 44.3 44.6 46.0
Firm E, Nov 1985 47.1 43.9 44.7 46.2
Inventory change n
Firm A -2.7 -0.2 - I.I 0.5
Firm B -2.9 -0.1 0.1 -0.5
Firm C - 2.1 0.6 0.1 - 0.5
Firm D -2.7 0.1 0.3 1.5
Firm E - 2.0 0.2 0 0.6
Non-OPEC supply
Firm A 27.6 27.7 27.9 28.5
Firm B 27.5 28.0 28.3 28.6
Firm C 27.6 28.2
Firm -D 27.4 28.0
Firm E 27.6 27.7
Demand for OPEC oil
Firm A
Firm B
Firm C
Firm D
Firm E
28.5 28.8
28.5 28.2
17.5 16.2 16.4 18.9
17.4 16.1 16.1 16.1
17.5 16.3 15.9 17.5
17.4 16.4 16.4 18.7
17.5 16.4 16.2
Projections of consumption and non-OPEC suppliers include
refinery gain of about 700,000 to I million b/d, unless otherwise
noted.
h Because of rounding, components may not add to totals shown.
I
46.0
47.2
44.5
45.2
46.7
45.9
45.6
46.8
44.1
44.5
47.0
45.6
45.4
47.3
44.0
44.6
46.1
45.5
45.5
47.2
44.3
44.5
46.3
45.6
45.5
46.9
46.9
43.9
46.5
45.5
-0.9
-1.1
0.4
0.6
-0.1
-0.8
-1.6
0.8
1.2
- 0.5
0
-0.5
- 1.5
0
0.5
- 0.3
- 0.3
-0.2
- 1.1
0.3
0.5
-0.3
-0.2
0.6
- 1.4
0.2
0.4
-1.1
-0.5
27.8
28.6
28.9
28.9
28.6
28.1
28.3
28.4
28.7
29.0
28.6
28.2
28.7
28.7
__
28.6
28.5
28.1
28.5
28.8
28.9
28.9
28.8
28.0
28.1
27.9
28.2
28.1
28.1
17.3
16.9
16.5
17.0
17.5
17.0
16.8
17.6
15.3
16.5
17.2
16.7
17.2
17.6
15.8
16.1
17.1
16.6
16.2
17.0
17.3
17.0
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Figure 8
Squeeze on OPEC Producers, 1979-85
Million h/d
t
1979 80 81 82 83 84 8
Rapid Increase in
Non-OI'I ( Oil Production
Milli ti h/d
' ti
Declining OPI (' Accrag
Official Sales Price
US S per harreI
;b
28 1980 81 82 83
Reductions in World
Oil Inventories
Million h/d
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believe, however, that any reduction in exports would
stem from domestic production difficulties, rather
than OPEC persuasion, and that this offer is just an
attempt by Moscow to use a domestic problem to
score points with conservative Arab nations. The
trade press reported before the December OPEC
meeting that the Soviets were warning longtime cli-
ents that 1986 contracts for crude oil and products
would drop sharply from 1985 levels, probably to
reflect more realistically what Moscow thinks it can
supply. According to our estimates, the USSR export-
ed approximately 10 percent less oil in 1985 than in
1984. The trade press reports that, for 1986, the
Soviets are reportedly willing to sign full-year con-
tracts with customers, but only at 60 to 70 percent of
1985 contracted volumes.
The Saudi Role
The level of production that OPEC ultimately decides
to defend will depend in large part on Saudi actions.
The Saudis have drawn down foreign reserves by
more than $50 billion between 1983 and 1985 to
finance current account deficits and are unlikely to
accept increasingly rapid drawdowns in 1986 and
beyond. We believe that financial considerations will
likely lead Riyadh to produce near-current levels of 4
to 5 million b/d even at the expense of sharply lower
prices. Short-term revenue needs have become the
driving force behind Saudi oil policy. As the swing
producer, the Saudis recognize that keeping 1986
prices at about $25 per barrel would require holding
their output to perhaps 2.5 million b/d-an unaccept-
able situation since revenues would approximate $15
billion. By comparison, at $15 per barrel and produc-
tion of 4 million b/d, Saudi oil revenue would approx-
imate $19 billion. This approach could also maximize
long-term revenues by keeping oil a more competitive
fuel. In addition to the revenue issue, the Saudi policy
shift also reflects an attempt to regain market share,
encourage greater discipline by non-OPEC and other
OPEC producers, and ensure a growing demand for
its oil over the longer term. Saudi oil minister Yamani
has frequently referred to the possibility of $18-to-$20
oil prices, and the Saudis, with ample excess capacity,
conceivably could boost output sharply in an attempt
to maintain revenue levels even if prices fell well
below $20 per barrel.
Other OPEC Producers
There is no indication that other OPEC countries will
voluntarily reduce output below recent levels of about
14 million b/d, including natural gas liquids:
? Most of these countries have seen steep reductions
in foreign reserves since 1980 or 1981. As a group,
foreign reserves fell almost 20 percent to $160
billion from 1980 to 1985.
? Even the wealthier OPEC members like Kuwait, the
United Arab Emirates, and Qatar have suffered
from the soft oil market. Lower oil revenues have
meant recession and payment problems. In addition,
ruling families are increasingly drawing criticism
because of poor economic conditions and profligate
spending habits.
? Completion of Iraq's spurline to Saudi Arabia's
East-West pipeline to the Red Sea has raised Iraqi
export capacity to 1.8 million b/d, some 400,000
b/d above the average 1985 production.
? The strong dollar, which provided some relief from
falling revenues in 1984 and early 1985, has weak-
ened by about 20 to 25 percent, bringing additional
pressure on these countries that import little from
the United States.
? As prices fall, reduced earnings will increase pres-
sures to boost output even further.
Countries with relatively limited excess available ca-
pacity in the near term may argue for OPEC produc-
tion restraint. Based on our capacity estimates, Alge-
ria and Iraq would be unable to increase production
much above current levels and would therefore face
sharply lower revenues if oversupply caused prices to
tumble. Even countries with substantial excess capaci-
ty would face serious marketing problems in an
environment of large oversupply and falling prices.
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Producer intentions and market forces point to a
continued decline in oil prices. Because predicting
how far prices will fall is difficult, we have looked at
two scenarios. The lack of any evidence that oil
producers are prepared to hold the line on output
makes us believe there is a 50-percent probability that
prices will average below $20 per barrel in 1986. This
is in contrast with the consensus in the oil industry
that oil prices will average about $22-to-24 per barrel
(figure 9)
Price Erosion
Under this scenario, average annual oil prices fall as
low as $20 per barrel. For this scenario to materialize,
OPEC would have to limit its market share to about
40 percent or less of non-Communist output-18
million b/d. Saudi production would have to average
about 4 million b/d unless other OPEC countries cut
back output. Although we have no evidence that
suggests a compromise is likely, the organization has
historically taken action only after a crisis is under
way. Many industry analysts continue to believe that,
if prices fall toward $20 per barrel or below, OPEC
would agree to restrain output, realizing that sharply
lower prices and revenues are worse alternatives. We
are less confident than in the past that OPEC is
capable of reaching a decision fast enough to halt a
downward price spiral once it begins.
Price Collapse
Annual average prices fall under $20 per barrel to as
low as $15 in this case. This represents an almost 50-
percent decline when compared with last year's aver-
age annual price of $27 per barrel. Under this case,
Saudi Arabia and other OPEC countries follow
through on their attempt to maintain production at or
near their fourth-quarter levels of 19 million b/d, and
competitive pressures force oil prices (figure 10). The
complexity of the international oil market and the
switch away from using official prices toward market
prices will make it difficult for OPEC to control a
rapid price decline. Unless short-term prospects for
demand improve more than expected, declining export
earnings will increase pressures to raise output even
more to maintain revenues. Although producers as a
Because oil demand is relatively unresponsive to price
changes in the short term, producers face the prospect
of lower revenues if prices fall. Based on the CIA
energy model, a $10 price drop would raise oil
consumption by only about I million b/d in the short
term: 25X1
? We estimate that, if oil prices fall to $20 per barrel,
OPEC revenues would fall by $24 billion. If prices
fell to $15 per barrel annually, OPEC revenues
would fall by one-third or by about $45-83 billion.
? Lower prices would also squeeze the revenues of
non-OPEC producers and could reduce the ability
of some LDCs, like Egypt and Mexico, to service
foreign debt.
According to CIA estimates, Mexico will lose about
$550 million in revenues for every $1-per-barrel drop
in the price of oil. This would be partially offset by
interest savings of approximately $130 million.
Therefore, if prices drop to $20 per barrel, Mexico
could require significant amounts of new money to
offset a net loss of approximately $2.7 billion.
25X1
group would register higher oil revenues by holding
down output and maintaining prices, the use of game
theory analysis suggests individual countries may 25X1
continue to try to undercut others to raise market
share. oil companie25X1
representatives were una e to estimate with any
confidence the floor price once the downward spiral
began. The key uncertainty would be how much oil
would be shut in at any given price and the short-term
demand response. Some industry analysts, however,
believe the floor price might be about $12 per barrel.
the further prices fall,
the faster they would rebound to about $15 per barrel.
At a floor price of $15 per barrel,F---Iprices
could be sustained for several yea
25X1
25X1
25X1
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Figure 9
Oil Price Scenarios, 1986
Soft landing S201o S25 per barrel
()PI'.(' adopts reasonable
production goal
Saudis restrain production
sshen demand falls in spring
Consumption rise,
hecansC of lower prices
Price collapse
$15 to 520 per barrel
OPEC maintains production
at December levels
Lower revenues
increase pressure for
still higher production
Soviets encounter
production prohIcros
December 1985, OPEC meeting
OPEC defends production
rather than prices
Price war
Prices Dill to
$IS per barrel or lower
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Figure 10
OPEC Supply and Demand Scenarios
Price
I rosion
Price
Collapse
Potential supply
overhang
1)crnand for OPEC oil
17 million h/d
Game theory is used to examine situations in which
two or more entities choose strategies that interde-
pendently affect each participant. It is essentially a
methodology for examining decisionmaking in the
face of uncertainty and predicting the behavior of the
participants. We have applied this approach to the
current oil market situation and the dilemma con-
fronting OPEC members. Our analysis indicates that
the Saudi decision to abandon the role of swing
producer created an unstable environment by convinc-
ing other market participants that prices would prob-
ably decline somewhat because of the absence of
adequate production restraint. 25X1
Under these circumstances, self-interest and rivalry
to increase or maintain market share can produce
intense competition and a price collapse. This result
is in sharp contrast to traditional economic analysis
that implies that producing countries will attempt to
avoid touching off a price war since each realizes all
would suffer from lower revenues. Game theory indi-
cates that recognition of the problem may not be
sufficient to prevent its occurrence given current,
diverse pressures on individual producers.
Even if OPEC gets through the next several weeks
without further price declines, oil producers will face
another difficult test as seasonal factors sharply cur-
tail oil consumption. We estimate that by early April
oil demand will fall by about 3 million b/d from
fourth-quarter levels. If producers do not have a new
strategy for voluntary production cuts in place, prices
will spiral downward.
25X1
Avoidance of a price collapse requires a mechanism
for cooperation and the exchange of information for
market participants to change their operational as-
sumptions about the behavior of other oil producers.
The existence of OPEC and the likelihood of discus-
sions between members of the organization and key
non-OPEC producers like those agreed to by Saudi
Arabia and the United Kingdom provide such a
forum. For prices to stabilize, however, producers
still have to use these mechanisms to convince each
other that an effective system of production restraints
can be implemented. 25X1
25X1
25X1
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A decline in oil prices is generally good news for
energy-consuming countries.' Low oil prices will help
keep inflation under control, give impetus to economic
expansion, and, for many LDC debtors who are net
energy importers, reduce the financial drain on their
economies. In addition to lower oil costs, these coun-
tries will benefit from a probable drop in interest
rates. Countries, like Chile and Turkey, whose exports
are heavily weighted toward oil-exporting countries
could, however, be hurt if the value of their exports
declines by more than the import savin s realized
through lower oil prices.
Many oil exporters will suffer economic setbacks if oil
prices decline. To compensate for lost revenues, debt-
troubled LDCs, as well as the wealthier OPEC coun-
tries, will probably be forced to draw down foreign
exchange reserves, cut imports, or obtain new money
from international creditors. Nigeria and Peru have
already restricted debt payments to a percentage of
export earnings.
We see the following as likely implications of our
average 1986 price scenarios:
? Prices at $20 per barrel. Export revenues of major
oil-exporting LDCs outside the Persian Gulf would
decline by as much as 35 percent. Mexico, Nigeria,
and Venezuela would see a deterioration in their
overall trade position and export competitiveness
and would probably be unable to obtain sufficient
new voluntary financing from commercial sources to
cover their losses. Algeria, Indonesia, and Egypt,
which are not yet considered troubled debtors, could
be pushed into financial difficulties. Iran and Iraq
would be pushed to make difficult decisions; with no
reserves and little opportunity to significantly in-
crease sales, they would register sharp increases in
their current account deficits (tables 4 and 5).
Table 4
Change in Real GNP Growth Rates,
$20-per-Barrel Oil Versus $26.50,
1986-88
OECD
0.4
0.8
0.3
United States
0.7
1.4
0.6
Non-US OECD
0.3
0.6
0.2
Canada
0.3
0.6
0.4
Japan
0.6
0.1
-0.1
Western Europe
0
0.4
-
0.3
Big Four
0
0.5
0.3
West Germany
0.1
0.6
0.4
France
0.1
0.2
0.4
United Kingdom
-0.6
0.6
0
Italy
0.3
0.5
0.3
Other OECD
0.2
0.1
-0.1
? Prices at $15 per barrel. Erosion of oil prices to $15
per barrel would push the financial needs of the
heavily indebted oil-exporting countries-such as
Mexico, Nigeria, and Venezuela-beyond the re-
sources of the Baker plan unless additional strong
austerity measures were taken. A decline could also
cause some countries to try to follow the examples
of Peru and Nigeria to limit debt service to a fixed
percentage of export earnings. At $15 per barrel,
Mexico, Nigeria, and Venezuela whose combined
external debt totals $155 billion-would stand to
lose nearly $20 billion in gross revenues in one year,
making their debt servicing burden untenable. The
current account deficit of all OPEC members as a
group would increase by more than $40 billion to
more than $65 billion in 1986 (tables 5 and 6).
For the Long-Term Oil Market
Lower oil prices could raise oil demand, slow supply
development, and hasten a return to a tight market
situation. Unless offset by tax hikes, lower oil prices
would dampen conservation and substitution while
boosting economic growth and oil demand. A decline
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Table 5
Oil-Exporting LDCs:
Impact of Changing Oil Prices
Million ('.5 S
(except where noted)
Revenue Loss
Interest Savings
Estimated
Export
Gains
Combined
Impact
Combined
Impact as a
Share of
Reserves
(Jun ccnt )
Algeria
- 1,661
38
49
1,574
58
Icuador
475
51
8
-416
71
Igspt
-650
26
16
--608
68
Indonesia
1,575
57
75
-3,443
71
\1alacsia
-546
11 1
41
- 394
9
Mexico
- 3,575
862
104
_2,609
58
Nigeria
- 3,630
169
46
3.415
416
Venezuela
- 3,322
205
45
-3.072
32
At gcria
2,938
67
91
2,780
102
Ecuador
840
90
1 5
735
1 25
Lgspt
I , 150
46
29
- 1,075
120
Indonesia
6,325
1() 1
139
--6,085
1 25
\1 aIassia
- 965
195
75
- 695
16
Mexico
6,325
1,5_25
193
4.607
102
Nigeria
6,422
299
85
6,038
735
Venezuela
5,876
363
82
- 5,431
58
Estimated export gains to OECD countries only.
Include central bank reserves less gold.
in nominal oil prices to $20 per barrel this year would Middle East, these producers would eventually recap-
reduce oil prices in real terms near 1973 levels (figure Lure market share if lower prices persisted for several
11). Based on the CIA linked econometric energy years, leaving the market more vulnerable to supply
model and industry estimates, a drop in oil prices to disruptions and renewed upward price pressure.
$ 15 per barrel this year could raise demand for OPEC
oil by about 10 million b/d by 1995, to 27 million b/d.
Given the long leadtimes necessary to develop new
supplies and the substantial excess capacity in the
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Table 6 Figure 11
OPEC Oil and Financial Prospects OPEC Average Crude Oil
Sales Price, 1973-86
Production
Total
Saudi Arabian
Kuwait h
UAE
Qatar
Iran
Iraq
Other OPEC
17,300
18,300
19,300
3,810
4,500
5,000
1,064
1,000
1,100
1,271
1,250
1,300
315
300
300
2,346
2,350
2,500
1,403
1,800
1,800
7,091
7,100
7,300
104.0
83.1
25.0
21.5
5.4
4.6
8.5
6.6
2.2
1.7
11.2
9.1
11.4
8.3
40.2
31.3
-44
--66
-23
-27
3
2
3
1
2
1
-4
-7
-6
-8
Revenues
Total 130.6
Saudi Arabia 27.5
Kuwait 8.2
UAE. 11.5
Qatar 3.1
Iran 14.8
Iraq 11.1
Other OPEC 54.4
Billion US $
Current accounts
Total -18
Saudi Arabia -18
Kuwait 5
UAE 6
Qatar 2
Iran -I
Iraq -5
Other OPEC -7 17 --28
Includes natural gas liquids.
Includes Neutral Zone.
Based on 1985 import levels.
Li.. 1 _11 I 1, l
1973 75 80 85 86,
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The unstable situation in the Middle East could
cause a turnaround in the oil market. Continued
Iraqi attacks against the Khark Island oil export
terminal increases the risk that Tehran may move to
interdict oil shipments from the Persian Gulf Teh-
ran's recent moves to build alternative export facili-
ties at Ganaveh and Bandar-e Taheri both of which
we expect will be completed by yearend-substantial-
ly reduces the risk that Iran will move against other
Gulf oil exports. Substantial surplus production ca-
pacity primarily in the Gulf countries provides the oil
market considerable,Jlexibility.
Although the risk is small, the loss of most Persian
Gulf oil supplies for a prolonged period could cause
oil prices to rise sharply. Last year, Persian Gulf
countries provided about one-fifth of total non-Com-
munist supplies. Most of the oil flowed through the
Strait of Hormuz. No new pipeline capacity avoiding
the Strait is likely to be added this Year, leaving less
than I million b/d of surplus export capacity in the
event of a Gulf disruption. Surplus available produc-
tion capacity averages about 11 million b/d, but only
about 3 million b/d of this lies outside the Gulf
region, with about one-quarter of that amount in
Libya. The United States, Western Europe, and
Japan import about 1, 20, and 60 percent of their oil,
respectively, from the Persian Gulf
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Secret
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