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Stop Blaming OPEC For Low Prices

Stop Blaming OPEC For Low Prices

We are a little more than a month away from OPEC’s next meeting, which will be held in Vienna on December 4, 2015.

OPEC altered the course of the oil markets last year when it decided to cast aside its traditional role of maintaining balance through production cuts. Instead it pursued a strategy of fighting for market share, contributing to an immediate rout in oil prices. WTI and Brent then went on to dive below $50 in the weeks following OPEC’s decision.

OPEC is widely expected to continue its current strategy at its next meeting, and as such, no rebound in oil prices is expected, at least not because of the results of the group’s meeting in Vienna.

But that raises a question about what the world of oil expects from OPEC: Why is it that the responsibility for balancing the market falls on OPEC? Why should OPEC be the one to fix the imbalances in the global crude oil trade?

Related: Day Of Reckoning For U.S. Shale Will Have To Wait

On the one hand, it makes a certain degree of sense that market watchers anticipated adjustment from OPEC. After all, the group has historically coordinated its production levels in an effort to control prices, or at least influence them. They could cut their collective production target to boost prices, and vice versa.

However, there is an element of imperialism and superiority in the expectation that the burden should fall on OPEC, which is largely made up of producers from the Middle East. It is a bizarre mentality to think that private companies deserve to seize as much market share as they can manage, after which OPEC producers can take what is left. Steven Kopits, President of Princeton Energy Advisors, laid out the concept very nicely in a Platts article earlier this year, in which he says the expression “call on OPEC” should be scrapped.

Kopits offers an interesting thought experiment. If the industry in question were, say, automobiles rather than oil, there is no question that such an arrangement would not be framed in the same manner. Imagine that the world thought it reasonable that GM or Ford could take as much market share as possible, and Toyota was expected to slash production if there weren’t enough customers left over. It is an absurd scenario, but not so different from the world of oil.

Why is it that we expect OPEC (and since Saudi Arabia is the only producer with the substantial ability to ratchet up and down production, we really are talking about Saudi Arabia) to cut output in order to help out American oil producers? Saudi Arabia and its fellow OPEC producers have their own interests, and if they believe producing at a certain level is prudent, it is a bit curious to argue that they are “declaring war on U.S. shale.” But that is exactly what happened last year when they decided to leave their production levels unchanged.

Related: Present Pain Leading To Future Risks In Oil Markets

Moreover, while cutting production would help to increase prices, OPEC would lose out from selling less oil. It is not clear why OPEC should, in effect, subsidize higher cost production from around the world. Saudi Arabia tried to cut production in the 1980s to rescue prices from rock bottom levels, but it only led to the loss of market share. It is no wonder that the oil kingdom is not keen to go that route again.

Even leaving all of this aside, it is hard to even discern that such a “war” is actually taking place. After all, OPEC has only slightly increased output from 2014, and much of it came from Iraq, which has been trying to increase production at all costs, regardless of OPEC decisions. Iraq is not subject to the quota restrictions, and so it is pulling out all the stops to increase output.

The U.S. on the other hand, has aggressively increased output. It is easy to see that much of the responsibility for the crash in oil prices stems from a massive spending spree in the U.S. shale patch, which increased output by around 4 million barrels per day between 2011 and the peak in 2015, nearly doubling production from 5.6 million barrels per day (mb/d) to 9.6 mb/d. OPEC’s production, meanwhile, hasn’t changed dramatically over the same time period.

OPECVsUSOil

(Click Image To Enlarge)

Related: Future Of Iraq’s Oil Industry Under Threat

In this light, why is it that OPEC’s decision to leave its quota unchanged in November 2014 elicited calls that the cartel was waging war? Why is the world not calling on U.S. shale producers – which have a much higher breakeven price – to get out of the business so that other oil producers around the world can survive? In any other sector, high-cost producers are forced out of the market. Nobody expects the stronger producers to cede ground to weaker ones.

U.S. production is now down by about 500,000 barrels per day since April. Oil prices will rise over the next year or so as U.S. shale is forced to cut back. That adjustment – high-cost suppliers forced out – is how markets are supposed to work.

Nevertheless, as OPEC heads to Vienna in six weeks’ time, there will undoubtedly be more headlines about OPEC continuing its war on shale.

By Nick Cunningham of Oilprice.com

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  • James on October 25 2015 said:
    I totally agree with this article.
    Its simply not understandable that most of excess production has come from US and still it is being blamed on OPEC.
  • Dan on October 26 2015 said:
    I believe the comparison with the automotive industry is in one way good, and in one way bad. When Toyota started capturing market share in the 70's, through their innovative approach to manufacturing (see 'SMED' where they built to order rather than mass produced and let the sales outlets do the rest), they were able to decimate US industry and become the world's largest automobile producer. However if they continue to manufacture vehicles such that the market becomes flooded and world prices for all automobiles drops, resulting in Toyota losing revenues of $100bln pa, it makes no sense for them to continue to produce at high volumes. Going back to their original philosophy, they only built cars to order, so why not Opec only producing to order? Collectively the losses to Opec countries far outweighs the 'potential' future benefit from rising prices. It is also clear that the harm to the non-Opec production is devastating for workers and companies alike. The Saudis / Opec are effectively dumping oil onto the market, while not at below cost, it is below the cost that the industry needs to reinvest for future production. The probable result of this will be much higher prices in the coming years, leading to higher costs for all users, probable global slowdown/recession, and increased volatility in all related markets. This is not good for the global economy. Therefore while no automotive manufacturer can cause a global recession (or conversely help global growth as may be the case now with low oil prices), Opec does have this ability and therefore also has a responsibility to maintain order within the markets. For 4 years we heard Opec talking of $100/bbl being their target, with a complete 180 degree turn in Nov 2014. It is also clear that while the US production has decreased, Opec has increased production such that they produce 1.5mln bopd above their own 30mln target. Oil clearly is a depleting reserve, and once a barrel is sold at $50 it can never be sold again in the future at $100, therefore the lost revenue will never be recovered. This clearly does not make sense, and many of the Opec member countries do ot agree with the Saudi's strategy.

    This leads to another question. Is the strategy really one of market share, or is it a political one in order to try and crush the Russian and Iranian economies, both clear enemies of the Saudis. SA has far more cash in reserve compared to these two countries, and can outlast them in any price war. How long can the Russian economy last at such low prices? Maybe when Russia is bankrupt 'Opec' will change their policy. If they do not, then Opec members will continue to overproduce in order to increase revenues, and their will be a price war within Opec also, leading to even lower prices, and potential civil unrest within those Opec countries that are hurting the most.

    Nigeria is unable to pay civil servants, Venezuela is clearly bankrupt, Brazil probably not far behind although they do not rely on oil revenues as much.

    There is a much bigger picture out there than purely market share, however it seems that oil analysts are scared of approaching the geopolitical aspects of this oil war for some reason?
  • Dan on October 26 2015 said:
    surely this explains more the reason for the oil price war. Saudi Arabia are clearly trying to cripple the Russian and Iranian economies so that they are unable to fund a proxy war in Syria?

    Http://oilprice.com/Geopolitics/Middle-East/Qatar-And-Saudi-Arabia-Threatening-To-Escalate-Syrian-Conflict.html
  • Lee James on October 26 2015 said:
    If OPEC were the world's high-cost producer, we might look to them to ramp down crude production. Last time I looked, our unconventional oil sector is the world's highest-cost producer. Who was it that said OPEC needs to budge?
  • Geoff on October 26 2015 said:
    This article loses all credibility when it says no argument has been put forward as to why they should cut prices. The argument is simply - they make way more money if they do. A 10% cut for a 100% price increase is not complicated. The strategy is costing OPEC countries hundreds of billions of dollars.
  • jrhouse5@gmail.com on October 26 2015 said:
    OPEC was formed for the benefit of OPEC members. They control the supply of a large share of the world’s oil production to essentially control its price - higher oil prices for their benefit versus a price war as seen now to their detriment. This worked when demand was always increasing at a high rate and the prospect of peak oil would drop the supply of non-OPEC production. Something happened along the way - economics. China high growth is normalizing. And high oil prices resulted in new technologies that allowed access to formally inaccessible oil. OPEC allowed oil prices to get too high and allowed the unconventional oil genie out of the bottle. It is going to take a while for this market to equilibrate to stable prices for all.
  • mulp on October 26 2015 said:
    drill baby drill!!!

    Lower oil prices creates jobs, higher profits, wealth prosperity!!!

    We should be cheering and demanding more oil production to double supply to create more consumer demand and jobs and profits and wealth!!!

    That is the essence of Reaganomics and supply side economics.

    Increase the supply and wealth and prosperity follows for everyone everywhere!!!

    Absolutely guaranteed by the world's best economists and conservatives!!!
  • oil_observer on October 27 2015 said:
    This will likely not end well for any of the producers. The purpose of an economic "cartel" is to impose its oligopolic powers on a market to the cartel's price advantage. (Market share is only meaningful if it leads to greater profits). In this regard, it appears that KSA and its OPEC faction badly miscalculated the effect of abandonment of OPEC's de facto role as the supply-side market maker.

    First, KSA miscalculated the magnitude of the price collapse - which is costs KSA $9-$12 billion a month in lost revenue (and $1-1.5 trillion dollars a year for the industry as a whole) - I have not seen any compelling evidence that the npv of this forgone income will ever be recouped by the Saudis or anyone else in either increased sales volumes or future pricing (and with every additional month the hole only gets deeper - at this run rate, IMF notes that KSA's foreign reserve would last only 5 years).

    The long-term cost of the increased uncertainty, speculation, volatility and dislocation (business hates uncertainty) may ultimately spur, not deter, a shift to alternative energy sources despite lower oil prices. Moreover, meaningless OPEC production targets also fosters a continued culture of OPEC members "cheating" (and who wants to join a cartel (tacitly or otherwise) where you think/know the other guys are untrustworthy cheats.... (OPEC's new motto of "every man [/member] for himself" is not a good one for a fostering a strong cartel.) Under these conditions, restoring a managed marketplace will be difficult for OPEC - even if the KSA faction of OPEC eventually wants to do so.

    I also think, KSA & Co. were mistaken in believing that a 1-2 year (or more) period of low oil prices would safely eliminate its non-OPEC rivals (US shale, tar sands, etc.) and significantly extend the "Age of Oil". For many of the long-term/capital intensive producers (tar sands, etc.) OPEC's timing was late. True, rivals have been forced to cutback dramatically on spending and new production (and some producers many not survive), but the oil controlled by these rivals (or their restructured successors) will not disappear and (as we have already started to see) the cost structure of these OPEC rivals may decrease significantly - not only through technological innovations ("necessity" being mother of innovation) and penny-pinching of oil field suppliers and workers, but also from a lowered cost basis of these restructured rivals. As has been reported, this "Frankenstein" scenario, may mean that OPEC/KSA's actions may result in tight oil rivals (who can ramp up production in weeks or months with millions, not years or decades with billions) who will become the de facto price setters going forward (not an good prospect for profit maximizing producer/cartel). It is as if KSA thought the "strong medicine" of low prices would kill the tight/shale oil "disease," but instead it may be more akin to a misuse of antibiotics where the target organism is damaged, but lives and the surviving ones are even hardier and more damaging to deal with.... KSA's path may also mean the diminution in the power, influence, (and wealth) of KSA itself - as it is no longer the effective head of a functioning cartel, but instead is just one more commodity producer (albeit a very large and low cost one) seeking to hawk its product where ever it can...

    If this is analysis is correct, then one has to wonder why would KSA/OPEC embark on such a folly. Many theories abound.... Political ones (KSA & Co. v. Iran, Syria, ISIL, Russia, secret deals with US/Kerry, etc.) or economic ones (KSA's Oil Minister Minister Al-Naimi's fear of reliving the 1980's experience - when KSA bore the brunt of oil cuts with little impact on prices - or a daring but poorly thought out reaction to the growth of US shale growth by an aging Al-Naimi - and the now dead King - men fighting yesterday's battles...) . Who knows....

    A far more interesting strategy would have been to try to use some variation of Game Theory (coupled with a much more robust reporting/monitoring program among OPEC members and even Non-OPEC members alike - Russia, Mexico, Kazakhstan, Brazil, Oman, etc.) to actively manage the growth of new oil in a way that would "balance" the supply/demand marketplace such that OPEC (and non-OPEC producers) could maximize profits in a stable market environment. While there will always be a "free rider"/cheating element (and many political, sectarian, legal, anti-trust and other impediments), global technology exists today to monitor oil flow that wasn't available in the 1980s to spot/control cheating... And with KSA power to "dump" to enforce market discipline, even the US and European Majors might have been tacitly enlisted to make the "right" choice (from a Game Theory Prisoners' Dilemma standpoint) in terms production growth....
  • Jack on October 27 2015 said:
    Can't say I agree with this article, it does not make a lot of sense. I can highlight just a few of the statements made to explain myself.
    "Why is it that the responsibility for balancing the market falls on OPEC? Why should OPEC be the one to fix the imbalances in the global crude oil trade?" - Because they control more than 40% of world oil and because they made the market unbalanced in the first place by increasing output in 2014.

    You said that "while cutting production would help to increase prices, OPEC would lose out from selling less oil" - That is totally incorrect; OPEC (at least their main suppliers like Saudi Arabia) ar LOSING money at the moment due to the low oil price but they are doing this only because they want to regain their market share from US shale which they also stated previously this year.I am sure shale produceres will optimise their cost and start producing again after the prices come back up even if lower than the previous 120$.

    The only way prices are going to come back up is if OPEC will decrease its output which some of their member countries have started to raise thei voices about. No matter what some might think, OPEC always had and always will pull the strings when it comes to the oil prices.
  • Matt on October 27 2015 said:
    If the Saudi's would just realize that once companies start producing from shale that it marks the official "scraping of the bottom of the barrel". Not all shale is profitable and only the sweet spots were/are truly profitable at even $100/bbl oil. If they have the long-term vision that many thought they had, they'd surrender market share for the 20 or so years it will take to fully exploit American shale resources and then begin to gain it back afterwards. They would save their reserves and keep their own incomes up (see previous comment about selling 90% @ $100 vs 100% at $50). No need to worry about other countries duplicating the American shale experience as the infrastructure simply isn't present to duplicate it.
  • Jamie on October 30 2015 said:
    Good article. This is just economics in process. High cost inefficient producers go to the wall whilst the 5 dollar a bbl Saudi crude keeps flowing. Tar sands, shale, deepwater and Artic are in trouble.
    The shale bubble caused by oil prices in excess of 100 dollars per bbl absolutely had to burst. The Saudis just chose when to apply the pin. If they had waited another year an even bigger bubble would collapse. This way the collapse will be sooner, smaller and shorter.
    Eventually a leaner industry will emerge with only the most efficient projects getting funded. The price will rise to a new and lower normal, somewher south of 100 dollars, and Opec will have a bigger slice of this pie. Ultimately battery technology and renewables will advance to a point that starts to dent oil's primacy in world economics and at that point oil will be in the endgame phase. Cashing out in this phase is the Saudi goal.

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