Saturday, 2 January 2016

Has OPEC lost control of the price of oil?

In the aftermath of another inconclusive meeting of the Organization of Petroleum Exporting Countries, oil prices have been testing their lows from the 2008-9 financial crisis,  For all the attention and speculation devoted to OPEC-watching whenever they meet, the question we should be asking about OPEC is whether the current situation shares enough of the elements that defined those periods in the past when the cartel's actual market control lived up to its reputation.
That reputation was established during the twin oil crises of the 1970s. US oil production peaked in late 1970, and to the extent there was then a global oil market, the key influence in setting its supply--and thus prices--passed from the Texas Railroad Commission to OPEC, which had been around since 1960.  From 1972 to 1980, the nominal price of a barrel of oil imported from the Persian Gulf increased roughly ten-fold, with disastrous effects on the global economy.

Just a few years later, however, oil prices collapsed.  OPEC's control was undermined by new non-OPEC production from places like the North Sea and Alaskan North Slope and a remarkable 10% contraction in global oil demand. The turning point came in 1985. Saudi Arabia, which had successively cut its output from 10 million barrels per day (MBD) in 1981 to just 3.6 MBD, introduced  "netback pricing" as a way to protect and recover market share.

That move helped set up nearly 20 years of moderate oil prices, during which OPEC's most successful intervention came in response to the Asian Economic Crisis of the late 1990s, when together with Mexico, Norway, Oman and Russia, it sharply curtailed production to pull the oil market out of a tailspin.

The proponents of today's "lower for longer" view of oil prices may see compelling parallels in the circumstances of the mid-1980s, compared to today's. Production from new sources, mainly US "tight oil" from shale, has created another global oil surplus. In the 1980s nuclear power and coal were pushing oil out of its established role in power generation. Now, renewables and electricity are beginning to erode oil's share of transportation energy, while the slowdown of China's economic growth and concerns about CO2 emissions raise doubts about the future growth of oil demand.

However, these similarities break down on some fundamental points. First, the production profile of shale wells is radically different from that of large, conventional onshore oil fields or offshore platforms. Once drilled, the latter produce at substantial rates for decades, while tight oil wells may deliver two-thirds of their lifetime output in just the first three years of operation. Sustaining shale production requires continuous drilling. In fact, new non-shale projects similar to the ones that underpinned oil-price stability from 1986-2003 make up the bulk of the $200 billion of industry investment that has reportedly been cancelled in response to the current price slump.

Another major difference relates to spare capacity. During most of the 1980s and '90s, OPEC maintained significant spare oil production capacity, much of it in Saudi Arabia. That wasn't necessarily by choice, but it was what enabled OPEC to absorb the loss of around 3.5 MBD from Kuwait and Iraq in 1990-91 while continuing to meet the needs of a growing global market. The virtual disappearance of that spare capacity was a key trigger of the oil price spike of 2004-8. (See chart below.)  A little-discussed consequence of OPEC's current strategy to maintain, and in the case of Saudi Arabia to increase output has been a decline in OPEC's effective spare capacity, to just over 2 MBD, compared to 3.5 MBD in the spring of 2014.

As a result, global spare oil production capacity is essentially shifting from Saudi Arabia, which historically was willing to tap it to alleviate market disruptions, to Iran, Iraq and US shale. The responsiveness of all of these is subject to large uncertainties. Iran's production capacity has atrophied under sanctions, and it isn't clear how quickly it can ramp back up once sanctions are fully lifted. Iraq's capacity and output have increased rapidly, but key portions are threatened by ISIS.

Meanwhile, US tight oil production is falling, although numerous wells have been drilled but not completed, presumably enabling them to be brought online quickly, later--perhaps mimicking spare capacity. How that would work in practice remains to be seen. One uncertainty that was recently resolved was whether such oil could be exported from the US. As part of its recent budget compromise, Congress voted to lift the 1970s-vintage oil export restrictions. Even with US oil exports as a potential stabilizing factor, a world of lower or more uncertain spare capacity is likely be a world of higher and more volatile oil prices.

Oil prices were largely unshackled from OPEC's influence last year, after Saudi Arabia engineered a new OPEC strategy aimed at maximizing market share. However, with oil demand continuing to grow and millions of barrels per day of future non-OPEC production having been canceled--and unlikely to be reinstated any time soon--and with OPEC's spare capacity approaching its low levels of the mid-2000s, the potential price leverage of a cut in OPEC's output quota is arguably greater than it has been in some time.
In 2016 we will see whether OPEC finally pulls that trigger, or instead chooses to remain on a "lower for longer" path that raises big questions about the long-term aims of its biggest producers.

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