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Where Will Oil Prices Go After Algiers?

Following the media spectacle that…

Euan Mearns

Euan Mearns

"Euan Mearns is a geologist and geochemist. In recent years he was a principal at The Oil Drum, the worlds leading energy blog, until it…

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OPEC’s $900 Billion Mistake

OPEC’s $900 Billion Mistake

With WTI falling below $40 and perhaps heading for $20, one needs to wonder if OPEC’s strategy is working out as planned? Why are they following this course and what are their goals? The face value explanation, accepted by many, is that OPEC is protecting market share especially against rampant supply growth in the OECD, namely in the US LTO (light tight oil) patch. This post examines how OPEC’s market share has evolved with time and with past swings in the oil price.

This turned out to be more complex than expected. But scrutiny of the data shows that following each of the three oil shocks since 1965 (Figure 1) OPEC market share AND oil price fell (Figure 3). The most recent trend follows the 2008-2014 highs and I believe it is this observation that is driving current behaviour.

Had OPEC decided to sacrifice about 5% market share they could have maintained price above $100 per barrel for years to come in which time the US shale bonanza may have burned out. It seems that OPEC may have made a colossal error that threatens to de-stabilize their member countries.  Related: China’s Stock Market Meltdown Dragging Global Markets With It

OPECMarketShare

Figure 1 OPEC market share is simply OPEC production / global production. It is very difficult to make sense of the data from this plot. In Figure 2 the variables are cross plotted against each other which does enable some sense to be made. Shock 1 = Yom Kippur, Shock 2 = Iranian revolution and Shock 3 = peak cheap conventional oil.

OPECMarketShareAndPrice

Figure 2 This chart cross plots the two variables shown in Figure 1. It should be obvious that there is no overall correlation between OPEC market share and price. The chart is a time series that needs to be read in a counter clockwise direction beginning in 1965. The arrow 2014 to today is conceptual since I do not have the BP C+C+NGL YTD data available. The arrow shows a very slight increase in OPEC share since their production has risen this year. The trends are summarized in Figure 3. The picture is clouded by the 2008/09 crash. These years are labelled 08 (8) to 14 (4). See text for further details.

Cross plotting market share against price produces a curious pattern which is a time series that describes different market behavior for different time segments (Figures 2 and 3). To read the plot you have to begin in 1965 and work your way around in a counter clockwise direction. Note that by 1992-2003 the market had almost gone full circle.

The period 1965 to 2003 is marked by two major events – the Yom Kippur war and the Iranian revolution that was followed by the Iran-Iraq war. Combined, these two shocks sent the oil price over $100 / bbl. The period 1979 to 2003 may be viewed as one of relaxation and adjustment back to the starting point. Post 2003 a new ball game began with a plateau in cheap conventional oil production. Using pre-2003 behavior to predict what might happen now is likely a major mistake!

OPEC’s market share has varied enormously from a high of 51.2% in 1973 that coincided with low price and a low of 27.6% in 1985 that coincided with an intermediate price of $60 / bbl.

OPECTrendsSummary

Figure 3 Summary of the trends evident in Figure 2.

There are three periods when OPEC enjoyed rising market share. The first, 1965 to 1973 had essentially flat prices. The second, 1985 to 1992 saw market share rising against a backdrop of falling price. The third, 2004 to 2014 saw OPEC market share increase marginally against a backdrop of rapidly rising prices.

The three cycles of rising market share are cancelled by three cycles of falling market share AND falling price. Each of these cycles occur after oil price shocks and OPEC therefore found itself in the early stage of such a cycle in 2014. Related: This JV Could Trigger A Shale Boom In An Unexpected Venue

If one looks at prior falling share cycles, 1974 to 1978 was not that bad for OPEC. They lost 5% market share and the oil price shed $5. The second falling share cycle, 1979 to 1985, saw market share fall 18% (39% in relative terms) and price fall by $45. This was truly a bad period for OPEC and I dare say it is this that Saudi Arabia wants to avoid this time. This period also witnessed global oil demand in decline as the global economy adjusted to the sharply higher oil price. Hence at this time OPEC were getting a smaller share of a smaller pie. The third falling share cycle, 2008-2014 has seen market share fall a trivial 2.5% and price fall about $8 from record highs. And in this period most OPEC countries have been pumping at capacity and at record combined levels over 36 M bpd C+C+NGL. 2008-2014 has been an amazing pink patch for OPEC, too good to be true and too good to last.

Have OPEC just made a gigantic blunder?

Has the current OPEC strategy of flooding the market with their cheap oil turned out as planned or has it turned into a gigantic blunder? Figure 4 shows schematically three scenarios and alternative courses that may have been followed. The first is where we were heading. With the flood of oil that has come to market in 2015 combined with weak demand it is likely that OPEC would have had to cut production incrementally to have maintained the trajectory of slowly falling share and price. Scenario 2 shows what might have happened with a continuation of recent policy of supporting price. Trimming 4 M bpd from production (5% share) incrementally may have maintained prices of $100 / bbl. Scenario 3 shows what has come to pass and where we are heading.

ConceptualOPECScenarios

Figure 4 Three conceptual scenarios for different courses of action that OPEC may have followed.

I think it is safe to presume that, with the benefit of hindsight, OPEC’s preference would be within the vicinity of the 2008-2014 cluster. At present it therefore looks like OPEC have made a gigantic blunder. Their actions can only be vindicated if they do manage to break the back of the US LTO producers and other OECD and non-OECD producers like Gazprom and to some time soon end up with significantly increased share and price. Since OPEC is already pumping flat out, the only way to significantly increase share is if global production falls. This would herald another global recession since GDP and oil consumption are generally correlated.

Had OPEC pursued option 2 they may have benefited from unpredictable global events working in their favor. In choosing option 3 they now appear to have elected economic suicide for many members. I’m sure that was not the intention. Related: Oil Price Collapse Triggers Currency Crisis In Emerging Markets

What happens next? I believe that OPEC and Russia will hang tough for a while yet, until at least US oil linked debts are re-determined at the end of the third quarter. The outcome of that is in itself uncertain. While most predict a blood bath in the LTO patch, and I am not disagreeing that this is likely, strategic events are unpredictable. There is much hubris involved on both sides. Will the USA really sit back and watch its shale industry get kicked into the long grass?

Near term I think it likely we see WTI flirt with $20 and Brent below $30. At that point the global oil industry will be on its knees, including OPEC, the OECD and Russia. Russia may then either join or form an alliance with OPEC and we then see production cuts, incrementally up to 4 Mbpd and the price rise back towards that magic $100 / bbl number. I think it is safe to say that the oil industry and global economy are equally focused on stability as they are price and many will be asking what was the point? Meanwhile, in an increasingly meta-stable world, events may sweep all this into oblivion.

Finally, a concluding thought. Had OPEC defended price as opposed to share they may have seen production fall by 5 M bpd and a price close to $100 maintained. The current course of defending 36 M bpd may take the oil price down to $20.

32 M bpd @ $100 is worth $1168 billion per year

36 M bpd @ $20 is worth $263 billion per year

The difference of $905 billion per year could make this one of the costliest blunders of all time.

NotionalValueOfOPECProduction

Figure 5 The notional value of OPEC production calculated by multiplying daily production by price by 365.

All data from the 2015 BP Statistical Review.

By Euan Mearns

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  • Stavros H on August 24 2015 said:
    OPEC is doing the right thing.

    You cannot do policy based on a few months of price-swings, but have to take decades under consideration.

    OPEC must demonstrate to every oil executive or energy minister on the planet, that investing too enthusiastically in marginal oil deposits should be done with extreme caution.

    The loss of a few months of revenue is inconsequential in relation to OPEC's grand strategy.
  • Bud on August 24 2015 said:
    You are missing some critical points. Natural gas is part of this picture. Most of the frackers produce both oil and gas and many have large positions in the utica and marcellus which are two of the largest gas fields in the world, developed just in the past few years. Both oil and nat gas are no longer a wild cat operation, but a relatively low risk manufacturing process. This is what has opec, and the saudis who have limited natural gas to export, so uptight. We no the switch from coal to nat gas cuts co2 drastically and has so already in the United States, so why are we not using executive power to clear the red tape and get the pipelines from the Appalachians built so we can get the gas to the major us population centers a few hundred miles away and then be able to export worldwide. This fight should be over, we should already be exporting so much oil and gas that opec has no choice but to take price over market share. The leave it in the ground argument holds no water as EIA just announced that vietnam, a fast growing economy, will increase coal imports, yes coal IMPORTS, in the next 30 years to fuel this growth. Wind and solar will be a small part of the mix. If solar makes so much sense economically, what is the issue with vietnam, and why would we not export LNG to them. LNG prices have dropped by half globally in the last year due to the oil price. Soros seems to be buying up coal exporters in the US as well. Clearly there is a coordinated effort to try and suppress economic development in America, but we shouldn't stand for it either from external or internal influence.
  • Jimmy Chickwood on August 24 2015 said:
    Problem is OPECs move got crackers that much more efficient.
  • Ricky on August 25 2015 said:
    Don't make yourself confused, OPEC wants to be in power same as US politically always wanted.
    So to be in control you must have the power to control others dictate what you want and achieve it by all means.
    For me its just poor sighted that with low price you can simply buy over your competition and that is what usually businessman does.
    You simply think in your perspective from US only oh OPEC is killing others by killing others.. Just ask yourself why US goes to war when it knows that it will lose citizens, kill its own civilian in the process and still does it. If there is nothing to gain nobody does it for free. Simple as that.
  • Eduardo on August 25 2015 said:
    Finally someone who gets the picture of the failed market strategy OPEC has been wagging against themselves. Stupid myopic short term mentality I hope we get rid of them for good as per my #ZeroElasticitySupply on Twitter #End2OPEC by the way Davros or whatever is your name make me Gyro and shut up!
  • Ian on August 25 2015 said:
    I'm not sure OPEC, or more accurately, Saudi Arabia really had much of a choice. If SA had reduced production to support price (no one else in OPEC would help) they would have had to keep doing it indefinitely, as there seems to be no limit to how much oil the rest of the world can produce at $100- $120. Fracking would have spread around the world and more of the Arctic would have been opened up. I don't think they engineered last year's price drop, but once it happened I think they saw the writing on the wall. Actually, I think they have been anticipating this for a long time. As their oil minister observed more than a decade ago- "the stone age did not end for lack of stones." And the oil age will not end for lack of oil. Demand for oil has been dropping in the developed world for half a decade. This is a long-term trend that will continue, spread to the developing world, and accelerate in coming years as more energy options become economic. In such an environment the smart strategy, especially if you are the lowest cost producer like SA, is to get as much of your oil out of the ground as quickly as possible, before the market dries up completely.
  • mulp on August 26 2015 said:
    OPEC is trying to fight non-fossil fuel alternatives. Electric vehicles, electric bikes, electric trains are both capital investments but also lifestyle. If you take the 1200 gallons of oil average for a household as the base, at $4 that is about $5000 in gasoline for millions of families earning only $30,000, and then you need to pay for payments on a car plus maintain a second car. In China and India and Africa the cost of oil makes alternatives desirable or needed.

    Once alternatives to burning oil are available and invested in, lowering oil prices to try to regain customers in the hopes of jacking up prices is not likely to succeed.

    Tesla is finding other markets for its battery factory, while Tesla cars are viable as high end luxury cars, with the next model being lower cost, but still in the luxury car class - economy luxury. But over time, economies of scale will drive down battery costs and car costs, and the charging infrastructure will be built. If OPEC tries to jack up the price, say because US fracking loses financing, or just to earn more profits while losing market share, others will jump in to the electric car market.

    In China and India are billionaires already building Tesla Motor companies, like BYD. For China, building electric vehicles for both the local market and export means less oil import costs in exchange for more jobs. Burning fossil fuels is a job killer if its cheaper than the alternatives - it can't create more jobs if it costs less.
  • Craig on August 26 2015 said:
    With China's economy slowing despite their latest financial moves to stabilize it, OPEC members are going to start rethinking their strategy of maintaining high production just to get swing producers like Russia and the U.S. out of the market. One has to keep in mind that China is OPEC's largest customer and when your number one customer starts reducing imports, OPEC may have to cut production sooner rather than later. Also, one has to keep in mind that many OPEC members need that price hike soon because their massive state budgets are burning through their financial reserves faster than expected. Only Saudi, Kuwait and the UAE can maintain for the long term, not so with Venezuela, Iran, Iraq, Libya and the rest of them. They need oil at $100bbl to pay their bills.

    Last thought. It may also be good old fashioned geopolitics being played out here as well; the U.S. and Saudis colluding to crash the oil market to punish Russia for its bad boy antics of late (Ukraine invasion). The Feds (Obama Admin.) don't care much for the fracking industry due to environmental concerns, so what's a few hundred thousand workers when we can bring the Russian economy to its knees. Nothing to back up this scenario, but I thought it was interesting when Putin visited OPEC hdqtrs. last month. Maybe he was trying to cut a deal.
  • D on August 27 2015 said:
    Maybe this has nothing to do with US shale or Russia. Is it perhaps possible that SA is doing this as a lesson to bring some discipline to OPEC and force the other countries to actually stick to their quotas in future?

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