In three months, ministers from the Organization of the Petroleum Exporting Countries (OPEC) will meet with other producers including Russia to discuss the fate of the current production cuts agreement that will end in March 2018.
There are two main options: Either to terminate it once it expires in March or to extend it beyond that month. There is a third way for OPEC to walk but it is not new and they have walked that way before many times and every time it proved difficult.
The quota system is not new. It is one of the oldest methods for the group to deal with the oversupply in the market and to target a fair price range. But the system is very problematic in its nature and it is not easy to implement as it requires much self-discipline by all participants.
So why has OPEC not yet resorted to quotas since the start of the fall in oil prices more than three years ago? And why should OPEC reconsider going back to quotas after all this time?
Starting with the first question. The market conditions were not the same when OPEC first implemented its quota system in the early 1980s or when it last implemented it in 2011.
One of the main problems is that quotas do not work well when the market is expanding or when the discipline of the members of the agreement is weak. In the 1980s, demand was falling strongly and there was almost no discipline. As a result some countries used to sell oil at $5 a barrel as one of the marketing officials recalls when he used to prepare invoices.
By 2011, the market was expanding and demand was healthy. And with supply disruptions from Libya and others, it was a golden opportunity for all to abandon the quotas and sell as much as they could. And they did. In 2014, demand did not grow by as much as everyone expected at the start of the year. So there was no expansion. Moreover, supply was abundant and that complicated the situation. Yet, OPEC countries lost their self-discipline after 3 years of heavy pumping and any call to curtail output was rejected.
Saudi Arabia’s former Oil Minister Ali Al-Naimi has explained that in his book “Out of the Desert.”
Saudi Arabia in 2014 reached out to everyone inside and outside OPEC to cooperate but no one wanted to join in imposing self-discipline on their production. Saudi Arabia decided then to let the market do the job and those who did not want to cut back then would be forced to cut later on.
Indeed, OPEC and others realized later that they could not let the market drive them so they went back to production management but this time with a different system.
Instead of quotas, OPEC and other non-OPEC oil producers including Russia — that refused to cut in 2014 — decided to reduce output collectively by 1.8 million barrels per day (bpd). Turning to the second question. Why should OPEC consider quotas today? The quota system is a fair system that allocates to each country a share that is proportional to its production capacity and other factors like its population size and its resource base. So instead of cutting, they can produce, but under an agreed ceiling. There are four familiar problems.
First, it is hard to agree on a certain quota for each country.
Second, it does not work if compliance is weak.
Third, it needs regular monitoring and adjustments in order to maintain the right level that keeps the market in balance.
Finally, non-OPEC producers are not familiar with such a system and some like Russia have internal issues to impose it on commercial companies.
Still, the main problem with it is that OPEC members are not endowed with the same capabilities.
For some like Algeria and Ecuador, they do not have reserves that can last 80 years like Iraq, Saudi Arabia, or Kuwait — so they need to pump at the highest rate at the soonest.
Others like Nigeria, Iraq, and Iran have large populations so they need more cash than others with small populations such as Kuwait and the UAE. So agreeing on a quota is hard and political ties have to be strong among countries in order for them to all come on board. Thus, OPEC heads of state need to meet more often. The last meeting was held in 2007.
What is more important is that OPEC members need to change their mentality and they must respect agreements and stop blaming each other on low compliance as OPEC veteran Abdulsamad Al-Awadhi said.
“An OPEC quota system with no discipline and at least a 75-percent compliance rate is destined to fail,” he concluded after spending almost 30 years with OPEC.
• Wael Mahdi is an energy reporter specializing on OPEC and a co-author of “OPEC in a Shale Oil World: Where to Next?” He can be reached on Twitter @waelmahdi