OPEC’s Three Options To Boost Oil Prices

After the initial short-lived enthusiasm over OPEC’s production cuts, the market started ignoring attempts by the cartel to talk up oil prices as it became evident that the glut would not clear as fast as expected. The extension of the output deal failed to lift the price of oil – in fact, prices plunged, with the market disappointed with the lack of deeper cuts.

OPEC’s policies to try to ‘fix’ the oil market and drive prices up have lost their previous relevance. In today’s market, OPEC is faced with rising output from short-cycle producers like U.S. shale, increasing production from other non-OPEC producers not part of the current deal, and dissent and increased output from within the cartel itself.

Looking at game theory, OPEC has three potential strategies to try to better manage the supply side of the oil market, and regain some of its lost relevance as a market force, Bloomberg View columnist Mohamed A. El-Erian suggests. Those different game-theory approaches involve either broader cooperation with other producers, or a more institutionalized plan for supervision of the cuts and incentives for cash-strapped members to prevent cheating.

Option 1 would be to try to muster a broader coalition to talk about supply issues, including U.S. shale, El-Erian says.

Considering how much U.S. drillers believe in the free market driving oil prices, and their general aversion to government and supra-governmental organizations ‘fixing’ production, this is the least likely strategy that could be implemented.

Strategy 2 would involve OPEC boosting cooperation with the non-OPEC producers that have joined the production cut agreement, and trying to plead for deeper cuts there. This approach could also seek to add stronger mechanisms to hold producers responsible for implementing their cuts, compared to the current ‘voluntary participation’. It could include a “stabilization fund”—as El-Erian put it—to help cash-strapped producers and incentivize them to continue sticking to the cuts.

Considering that within OPEC itself, compliance is waning, with producers pumping more to generate revenues from volumes rather than waiting for prices to rise, making the group led by Russia increasingly unlikely to cut further. Related: Goldman Sachs Vies For Role In Aramco IPO

A joint OPEC/non-OPEC technical committee will be meeting in Abu Dhabi early next week to discuss ways to improve compliance by members that have not been sticking 100 percent to their output quotas so far.

Seven months into the deal, the first OPEC member publicly admitted it wanted out—Ecuador broke ranks last month and announced that it would no longer stick to cuts because it needed to boost its oil revenue.

Finally, strategy 3 for OPEC —according to El-Erian—is the good old ‘drown the market in oil and kill U.S. shale’.

Although the policy to flood the market with (even more) oil, pushing prices so low that U.S. drillers are driven out of profitability, would stop the shale resurgence, OPEC would be shooting itself in the foot with this. Because, even though heavyweights Saudi Arabia, Iraq, and Iran still boast the lowest breakeven prices to churn out profits from new developments, their fiscal break-even prices—the price of oil per barrel needed to balance their budgets—are much higher. According to a Goldman Sachs report from last month, quoted by Bloomberg, OPEC on average would need oil prices at US$70 to balance budgets this year, which is higher than the US$40-US$60 per barrel oil price that the world’s biggest listed companies need to pay for capex and dividends.

At low oil prices, Middle Eastern economies may have to resort to additional austerity measures like cutting subsidies and lavish perks for public servants. And with oil prices too low, the valuation of Saudi Aramco in next year’s planned IPO may not be even close to what analysts expect now.

OPEC is currently in a tight corner, but its game-theory options are all so difficult to implement that the cartel may be facing ever-diminishing market relevance and price-setting power.  

By Tsvetana Paraskova for Oilprice.com

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