Why OPEC Needs Higher Oil Prices

Apr. 7.11 | About: iPath S&P (OIL)

OPEC is about to make history. According to the International Energy Agency, the oil cartel will make $1 trillion in export revenues this year, a new all-time high. Talk about a gusher!

Oil now costs more than $100 a barrel. And oil production has been on the rise as well. If that status quo remains, OPEC can expect a very good 2011.

Its heady situation once again emphasizes oil’s importance in the global economy. And its significance will only grow as developing nations – from China to India to Brazil – demand more energy. But there are plenty of other factors at play that will keep oil prices high going forward.

OPEC’s Spare Oil Capacity Seeping Away

Supply disruptions present the most immediate concern for markets. Libya used to be the world’s 12th largest oil exporter, producing about 1.6 million barrels of high-quality crude oil daily. Since war first broke out there, Saudi Arabia and other leading OPEC members have rushed to offset the shortfall.

Yet OPEC’s spare capacity is still dwindling – now to under four million barrels a day. That’s much better than the 500,000 barrels a day after Iraq went offline in 2004 following the 2003 U.S. invasion. But it’s also well below the 2009 peak of seven million, and it could drop even further.

In reality, OPEC could use up its entire spare capacity as protests continue to spread. Take Bahrain, Oman, Syria and Yemen, which are all experiencing unrest. Alone, they don’t produce that much but, together, they contribute 1.5 million barrels a day. If they go offline, oil prices will rise.

That’s partially due to the oil market demanding a bigger price premium every time OPEC’s spare capacity shrinks. That premium will go towards offsetting the risk that another big disruption will force the system to run at full capacity.

Why OPEC Needs Higher Oil Prices

Also affecting prices, certain oil-heavy governments are turning toward populist policies to quell political unrest. Take Saudi Arabia’s King Abdullah, who is boosting public spending and handouts. That includes one-off bonuses for public sector workers and building half a million homes at affordable prices. Together, those actions cost $129 billion, equal to over half the country’s oil revenues last year.

Many veteran oil watchers expect the extra spending to lift Saudi oil revenue needs to a percentage basis closer to Venezuela or Iran’s. Both countries are well-known oil price hawks, always pressing for much higher prices. In Saudi Arabia’s case, it will likely pay for its spending spree by tapping its $450 billion in reserves. But even then, prices will have to average $83 a barrel this year for it to balance its budget. Just a decade ago, it only needed $20 a barrel to achieve that same goal.

Higher Oil Prices Are Here to Stay

Unfortunately for consumers, higher oil prices are here to stay. The Institute of International Finance notes that Saudi Arabia will only be able to balance its budget if oil prices are at $115 a barrel in the future. And it isn’t the only one that needs prices to climb further; other members of the six-nation Gulf Cooperation Council are announcing similar spending plans. Kuwait, for one, will issue a $4,000 one-off bonus per citizen and free food staples for more than a year.

Such social spending will press oil prices higher still. It will also reduce available funds for state-owned oil companies to invest into adding future production capacity. And as governments in the region continue to feel under threat from social unrest, they are less and less likely to cut into public energy subsidies. Those policies have made fuel cheaper than water in many of those countries.

Subsidies have led to runaway domestic growth in oil demand. Over the past decade, that demand has dented the region’s ability to export oil. For example, oil demand in Saudi Arabia has doubled over the past 15 years. That transformed the country into one of the world’s top 10 oil consumers.

If the trend continues – and it probably will – the larger Middle East will have less and less oil to export every year. And that means higher and higher prices for everyone else.