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Michael McDonald

Michael McDonald

Michael is an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance…

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Is OPEC Too Big To Fail? Not Anymore

Is OPEC Too Big To Fail? Not Anymore

A lot of people, including several OPEC members, thought the oil slump would be easing by now. Instead, as oil prices languish near multi-year lows and experience unprecedented volatility, it’s now unclear how long it will take oil prices to recover. Indeed, OPEC now appears poised to wait out the period of low prices even if that takes months or even a couple of years.

The fact of the matter is that despite the calls of Venezuela and Algeria, Saudi Arabia and other major OPEC members don’t seem too concerned about the current low prices. Venezuela in particular has been calling for emergency action for nearly a year now with essentially no effect.

OPEC’s willingness to wait on prices is causing some commentators to wonder if OPEC is “winning.” There is certainly little doubt that OPEC appears poised to keep its own production levels where they are, especially with the possibility of Iran bringing new supply online in the next year or two. Instead, the production declines in global output thus far have largely been a byproduct of falling production from non-OPEC unconventional sources. Related: Desperate Putin Not Giving Up On Asia Just Yet

Non-OPEC producers have largely been the swing producers for this oil price cycle, cutting production massively as prices have fallen, having raised production enormously as prices held at high levels in the last few years. The IEA sees non-OPEC production growth grinding to a halt over the next year which should eventually be supportive of oil prices. That is consistent with OPEC’s view that with a rebound in Chinese demand, oil could start to increase in price again next year.

The broader question remains as to how any rebound in price would impact supply. As unconventional producers like U.S. E&P firms have become more efficient over the last year of the downturn, they should be increasingly well-positioned to quickly ramp up production again in the face of even a small rebound in prices. While the firms may not be able to compete with Saudi Arabia itself on production anytime soon, it is entirely possible that many other OPEC nations may find that their production costs are soon rivaled by U.S. E&P firm costs. Related: Alberta’s Oil Companies Warn Government On Taxes

None of this changes the fact that OPEC’s production is holding steadier than non-OPEC production, or that OPEC appears to have the political and economic will to wait out prices. But then OPEC is formed from countries rather than companies, and the two sets of entities have very different objectives. OPEC nations have to be concerned with saving face, preserving market share, and their own regional power.

In contrast, the only goal of a firm is to make money. Thus, to the extent that U.S. E&P firms get to the point where they can easily ramp up and down production based on price, OPEC could find itself outmaneuvered. In a world where firms can easily ramp up production any time prices rise, it becomes almost impossible to “wait out” such firms if you are OPEC. Related: One Long-Term Bet On The Future Of Nuclear Energy

Now to be fair, it is certainly true that shutting down production entirely hurts a firm. In that sense, firms can never be truly 100 percent flexible with their production. In a period of low oil prices, a firm that has to shut down entirely won’t emerge unscathed. They still have fixed costs after all and might even go bankrupt if they have to pay those costs with no production. So it’s not realistic to say that firms will ever get to the point where they don’t care about oil prices. Still the fact that firms can respond more rapidly to prices than OPEC can, and the fact that firms do not make public announcements as OPEC does, means that, over time, a flexible firm could essentially front-run OPEC based on its own production reports and meeting statements.

The IEA is of the opinion that prices may need to fall further in order to slow production enough to really reduce supplies, but perhaps that misses the point. Supply is a function of price, and if OPEC forces U.S. producers to become more effective in their own operations, then in the end that simply hurts OPEC’s own ability to control prices. There is nothing worse for a lumbering cartel than a nimble firm that can jump in and take profits whenever an opportunity presents itself. With that in mind, perhaps OPEC should spend less time waiting and more time figuring out how to optimize its own operations in response to prices.

By Michael McDonald of Oilprice.com

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