OPEC faces a triple dilemma over the short, medium and long term, none of which have good outcomes for the cartel. The short term is simple; prices are likely to correct into 2013 below price bands that are deemed economically and politically comfortable. That strikes on OPEC’s medium term problem; the geological cost of production is now structurally out of sync with the geopolitical cost of survival. When OPEC doesn’t get the petrodollars they need to appease restive populations, the default position will be tough political repression to tighten their grip on power. Whether that ‘works’ as an effective coping mechanism remains to be seen; political outages might well help to lift interim prices, but this merely highlights OPEC’s long term nadir. The higher prices go, the more demand will fall – and more importantly – non-OPEC production explodes beyond the cartel to drive down prices. Any way you look at it, OPEC’s triple dilemma doesn’t have any easy exits.
The short term first. Although we currently have a lot of political froth bubbling away in the oil market cappuccino, ranging from US elections to third party attacks on Iran – once the bubbles deflate – then supply-demand fundamentals rest on the downside. Inventories are high, and demand looks increasingly weak in Asia, America and Europe – growth will be tepid at best, and could see outright contraction if the Eurozone saga plunges the world back into deep recession. $100/b will be gone, the core question will be how low prices go and how long for: $90, $80, $70, $60? Place your bets accordingly.
The ‘exact’ number doesn’t actually matter. Anything below $100/b is deeply problematic for OPEC over the medium term, precisely because they need high prices to politically survive. Even we take conservative fiscal breakeven prices over nominal budgetary figures, it’s pretty clear that the geological cost of production is now catastrophically out of kilter with the required geopolitical cost of survival. $100/b is new the $30/b compared with the early 2000s keeping producer states in the black. There are no true ‘price moderates’ left in the cartel, merely ‘gradations of hawks’.
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When the market turns, price wars will rage across OPEC to set an effective price floor, and it will be Saudi Arabia that’s expected to provide the wood and nails. But even KSA has a fiscal breakeven price of $94/b in 2012 and requires over $100/b to generate a surplus in 2013. Supply restraint will inevitably slip across the cartel, not to mention a free riding Russia exacerbating the problem. When petrodollars don’t ‘add-up’ and fiscal gaps start to show, then political pressures will rapidly grow – not just on the popular street – but deep within political elites as well. Unfortunately, rather than engaging in any significant political ‘reform to preserve’ when prices dive, producer states are far more likely to fall back on crude repression as a make-shift coping mechanism. Relatively small economic margins could have dramatic political effects, particularly when we consider that military hardware remains the last line of political resort, and in some cases, the first for producer states. Whatever popular compliance OPEC can’t buy with money, the use of force is the logical plan B.
The ‘problem’ is that repression isn’t the tool it once was. It didn’t work for Ghaddafi in Libya and’s unlikely to work for Assad in Syria. As fierce as rear-guard battles have been, they’ve not been militarily conclusive or operationally conducive to ongoing hydrocarbon production. The lower prices fall, the more likely it is political unrest will create serious supply disruptions when producers go offline, falling under the weight of their own (military) contradictions. Assuming smaller players implode first, that might be ironically good news for larger producers able to stick things out and wait for prices to lift on the back of supply side disruptions. But OPEC heavyweights shouldn’t be fooled that this is a ‘solution’ to their structural pricing problems.
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If anything, it strikes at OPEC’s third dilemma: Even if prices lift to buy them more time, higher prices are the core of the cartels long term demise. Not only will it reduce secular demand, it will encourage non-OPEC supply (both conventional and unconventional) to explode. Around 200 billion barrels of global proven oil reserves have been added over the past five years, most of which is beyond OPEC states. Once capital goes into conventional plays, variable costs are low relative to fixed costs. Economically, they’re what you could call ‘I’ve started so I’ll finish’ projects. Unconventional fields swing the other way; variable costs are high, which means supply is much more responsive to short term price. Higher prices will induce and maintain higher production. And you’ve guessed it; that inexorably leads to lower prices over the median term. OPEC can’t win any way.
So the cartel not only has a triple dilemma, it’s a devilishly cyclical one. OPEC needs the golden eggs from high oil prices to forestall domestic unrest, but it needs them at a rate that will ultimately kill its supply goose. Once market control is lost - the political implications don’t bode well for OPEC’s world - in what will become a lower price universe. Hence the real question is whether it’s going to be a slow and painful demise for the cartel, or a quick and brutal one. Only time will tell.
By. Matthew Hulbert