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Peter Tertzakian

Peter Tertzakian

Peter Tertzakian is Chief Energy Economist and Managing Director at ARC Financial Corp., Canada’s largest energy-focused private equity firm. His career began as a geophysicist…

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Production Cuts vs Innovation – Why OPEC Has Lost The Oil Price War

Permian Basin

OPEC and its cartel of friends must be sweating condensates in advance of their May 25th meeting.

The oil price war, triggered almost three years ago, is far from over. Calling a truce with production cuts has been an ineffective strategy. In fact, it’s been a feeble strategy and nobody in the business should rely on its extension to be effective.

Price wars are often triggered by the arrival of a new entrant into an entrenched market clique.

American light tight oil began flowing into petroleum supply chains in 2010. By 2014, output from plays like the Bakken, Eagle Ford and Permian had penetrated 4 percent of the world’s oil market, antagonizing starched interests in the industry.

There is a standard script for price wars that is played out in many businesses, not just oil. Airlines, pizza parlours and makers of high-tech equipment know the story line well.

Act I is the arrival of an antagonist, a new actor who tries to steal business from the old.

In Act II the leading defenders of market share lower their prices, flooding the market with cheap supply. The intent is to flush out the newcomer. Weak competitors are targets too.

By Act III all participants are overproducing to salvage market share. Prices collapse before intermission. Related: An Extension Is Not Enough – Why OPEC Needs To Cut More

Tension peaks in Act IV as bankruptcy and distress claims high cost producers. The denouement takes place in Act V when surviving participants capitulate and the market returns to balance. Survival is predicated on financial strength, innovation and reducing costs.

Curtains close on Act VI, by which time long-term pricing returns to the market (often at lower price points than before the price war).

In today’s oil drama, the resilience of many actors in Act IV (Bankruptcy and Distress) has been surprising. Producers like China, Mexico and Venezuela have seen their output decline due to underinvestment. But the declines have not been broad based; others have risen. Overall capacity shrinkage has not been fast enough to end the Act.

Act V was supposed to be when everyone capitulated. Surprise: Instead of being flushed out by lower prices, North American producers have been aggressively increasing productivity and driving down their costs.

The 2016 OPEC deal propped up prices, which was a gift to U.S. and Canadian producers to keep going up the learning curve. While hard data is not all available yet, the EIA estimates that U.S. rig productivities in major tight oil plays have increased by over 7 percent in the past six months, Canada’s operators are making similar gains.

OPEC’s issue—and other actors who are relying on OPEC for reprieve—is that the cartel is not following the correct script for ending a price war. Contrived “supply management” is not effective against a challenger that is bulldozing into the market with relentless innovation.

The appropriate defense against an innovative competitor is to innovate even faster.

In fighting a price war, closing a valve is not high up on the scale of innovation. Related: Oil Below $65 Per Barrel…For Years

Tooling up to use the latest sub-surface processes and applying digital technologies is the future of low cost oil extraction. That’s what leading producers in the U.S. and Canada are doing. And it’s why another OPEC deal is a fruitless strategy that merely extends Act IV: the demise of the inefficient.

Producers who are hiding behind a curtain of OPEC cuts are getting a misguided message. The implied narrative is, “Don’t worry, there is no need to improve your business practices and lower your costs through innovation. Everything will return to the good ol’ days once our supply cuts clear out the excess inventories of oil.”

On May 25th, oil markets are expecting that the OPEC-and-friend’s cartel will extend their supply quotas. And they likely will. However, the proper script would be to abandon the strategy of output cuts and let the market naturally choke off investment to the inefficient. Act IV can then play out faster, causing the production declines of high-cost defenders to set in faster.

Oil producers that follow the proper script of a price war will stay in business well after the curtains close. Those who don’t will die on stage from the sword of innovation.

By Peter Tertzakian for Oilprice.com

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  • Guy Minton on May 09 2017 said:
    Yes. Keep pumping the price down to move up the timeframe for the $150 per barrel oil.
  • EdBCN on May 10 2017 said:
    Well argued! The technology side of this is being under appreciated, but in the end oil isn't a mass manufactured technology, it's a natural resource with natural limits. But you're right that technology is going to stretch those limits a lot farther than most people think possible.
  • spinner on May 10 2017 said:
    The problem for Saudi Arabia and others is that their minimum cost isn't controlled by costs related to production rather that they have got used to public spending in their economies at a certain rate. Their production costs are already lower than shale so there's no incentive to innovate. At some point they will need to accept they don't control the oil price to the degree they used to US shale producers do.
  • TM on May 10 2017 said:
    Very good article. One thing that should also be taken into account is that OPEC countries simply can not win this war because they are rentier states. That means that even if they could innovate like US shale (which they can't because they lack the necessary skills and technological knowledge) and bring their cost down to zero (something impossible, of course) their cost would remain very high, because it is not defined just by their CAPEX, operational costs, R & D, etc. Instead, their main cost is in fact providing welfare to their populations, and that cost will always be there and can't be reduced by innovation. So they need permanently high oil prices in order to survive. Since keeping oil prices under control and permanently high is clearly impossible in the new context of technology breakthroughs prevalent in today's oil industry, it's not difficult to conclude that petrostates are doomed. The only solution would be to develop a diversified economy to make sure OPEC countries find other sources of substantial income, so that their national oil companies could operate like their western counterparts. But in order to do that they would have to change their cultures and mentalities. That could take a generation or two, even in the most optimistic scenario, and petrostates do not have so much time ( I won't even talk about Saudi Arabia's Vision 2030 plan, because this plan, designed by a subcontracted consultancy company, is clearly a mirage and wishful thinking).
  • david on May 10 2017 said:
    Great article and good perspective on where the US wants to be in the next decade. If only innovation could stop the decline curve.

    The bottomline is, the US is not quite there yet...so, today, production cuts win over innovation. In the next decade, when the US becomes a true player in exports and our innovation should change the oil markets for a more stable price.

    But that's not today.
  • Brian on May 10 2017 said:
    01.06.2016 Saudis Have Lost the Oil War

    Poor Saudi Arabia. They don’t realize it yet but they have lost their oil war. The war in its current phase began in September, 2014, when the dying King Abdullah and his Minister of Petroleum, Ali Al-Naimi, told US Secretary of State John Kerry they would gladly join Washington in plunging world oil prices.

    http://journal-neo.org/2016/06/01/saudis-have-lost-the-oil-war/
  • Russ Ramey on May 11 2017 said:
    Great article, Economics 101 along with Wealth of Nations. The feckless cartels are losing their grip.
  • RD on May 15 2017 said:
    did they really? how much more conventional or shale would be currently be prodcuing or coming on line had they not flooded the market and prices stayed at 100$/bbl. even the shale plays took a big hit. I can't remember the number but multiple millions of bpd (both conventional and tight oil) has been deferred with majority having long lead times..hell even ramping up shale is not an overnight venture. I might argue they accomplished more than we believe. Hearing the rhetoric about innovation is laughable...the innovation (or high grading) was going to happen regardless of price. Saudi plays a long game. They realize tight oil is going to be part of the market. Their target was much more than tight oil. IMO

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