*This article was first published on Prodavinci in Spanish.
In a two year time frame, the OPEC decided to take two diametrically opposed oil policy directions. This reflects both the profound differences between the member countries of the Organization and the changing power relations between the world’s major oil producers. In any case, it is a sign of the loss of power of OPEC in a market that is very different from that of forty years ago, when the Organization could exercise its monopoly power to dictate prices unilaterally.
At ordinary meeting 166, held in Vienna on November 27, 2014, OPEC member countries, led by their top producer Saudi Arabia, decided not to open market space to accommodate growing US production. In fact, OPEC’s decision was the declaration of a price war in order to force the fall of production of non-conventional crude in the United States. At that time, the widespread belief was that US production of non-conventional crude was uneconomical at below $ 70 a barrel. Conventional wisdom was that at prices below that level, there would be no new developments and existing production would fall precipitously. As such, OPEC would gain market share and would again be able to dictate global oil prices.
At OPEC extraordinary meeting 170, held in Algiers on September 28, 2016, the member countries, with the consent of Saudi Arabia, decided in principle to reduce their production. This was done to prevent prices from collapsing below the then current level of $50 per barrel. The decision about the size and allocation of production cuts among different member countries will be made at the next ordinary meeting 171, to be held in Vienna on November 30, 2016. Just two years after the meeting at which the price war was decided, the plans are to curtail production to defend prices. However not to defend prices at $100 but at half that level. What happened during these two years and where did the 2014 Saudi strategy was wrong? More importantly, what can be expected in the near future?
OPEC made the declaration of war clear two years ago when countries increased production by more than two and a half million barrels per day between January 2015 and August 2016 (the latest month for which data is available). However, the production increase was not uniform among OPEC countries.
OPEC Persian Gulf
Saudi Arabia and its allies in OPEC, Kuwait, Qatar and the United Arab Emirates, all members of the Gulf Cooperation Council, increased their output by more than one million five hundred thousand barrels a day. These four countries combined generate more than half of OPEC production.
Iraq and Iran, the other two Persian Gulf producers, also increased their production for different reasons. Iraq did it to pay for war expenses and Iran did it to restore production to levels seen before the country was sanctioned for its nuclear program. The two countries combined have increased production to almost two million barrels per day.
The six countries bordering the Persian Gulf OPEC members increased their joint production to more than three and a half million barrels per day while the Organization as a whole increased production by two million five hundred thousand barrels per day.
The Rest of OPEC
The other OPEC countries, all outside the Persian Gulf, far from increasing production, decreased it by one million barrels per day. The bulk of this decrease, about eight hundred thousand barrels a day, is concentrated in three countries – Libya, Nigeria and Venezuela. Half of this decrease – more than four hundred thousand barrels a day – is in Nigeria, as a consequence of the war in the Niger Delta. In Libya the decrease since January 2015 represents fifty thousand barrels per day. However, if you use January 2011 as a reference – before the start of the internecine war in the country – the decrease represented more than one million four hundred thousand barrels. Finally, the fall of Venezuela nearly three hundred thousand barrels per day, follows the collapse of the oil sector of the country. The five remaining OPEC members have collectively cut production by two hundred thousand barrels per day over the past two months.
A synthetic way to understand dynamics of OPEC over the last two years is: the six Gulf countries increased their production by three million five hundred thousand barrels per day, while the remaining eight countries reduced their production by one million barrels per day for an overall increase in OPEC of two million five hundred thousand barrels a day.
As a consequence of the sudden increase in the production of OPEC countries, prices fell to a low of $30 per barrel in early 2016 and since April have ranged between $40 and $50 per barrel.
Where the vast majority of the oil market analysts went wrong was in underestimating the resilience of oil production in the United States. Oil production in this country fell only three hundred thousand barrels per day between January 2015 and August 2016. Far from collapsing at prices below $70 a barrel, US production has fallen by only 3%, at prices that have averaged $45 per barrel in the last 20 months. In fact, investment in the production of non-conventional US crude has been rising since last April and is forecasted to stay at current prices of between $45 and $50 per barrel, and the production of non-conventional oil may increase between six hundred and seven hundred thousand barrels per day over the next year (WSJ 9/27/16). Thus the United States would reach historical record production levels and be established as the world’s largest producer. In fact, the potential OPEC cut may be covered by increases in US production at current prices and not have an effect.
What OPEC strategists did not anticipate two years ago was the potential for productivity growth in different segments of the production of non-conventional crudes – particularly in the two basic operations for production: horizontal drilling, reaching deeper strata and continuously increasing the perforated length, and in the techniques of hydraulic fracturing of rocks, permanently increasing the initial amount of oil produced by fracking. The cost of production of these crudes has been halved in the past two years, and productivity continues to increase.
The reason for massive increases in productivity relates to the needs of hundreds of companies in various business segments of non-conventional crude to compete with each other to stay in the market with prices that have fallen by half.
Saudi Arabia, a country that leads the core countries that produce more than half of OPEC crude, faces two dilemmas that will be difficult to solve if they want to avoid a further collapse in prices. The first is how to distribute the necessary cuts among all OPEC members. The second is what to do if, at current prices, US production steadily increases.
As for the first, it is difficult to expect the eight countries outside the Persian Gulf, who have seen their production fall substantially, to accept any cuts. On the opposite, countries experiencing civil war like Nigeria and Libya will increase production to pre-conflict levels as a modicum of stability is restored. Iraq and Iran will argue for something similar because they are countries that want to return to the level of prominence they had in the past. It seems that Saudi Arabia and its GCC partners will have to assume the bulk of the cuts, to the cuts having a minimum credibility. In late November, we will see how the cuts are allocated and if they will be agreed upon in the coming months.
The second choice is the more complex prediction. If indeed the producers of non-conventional oil in the US can increase output at prices around $50 a barrel, Saudi Arabia will have to decide whether to further reduced its production to make room for incremental production in the United States. It declined to do so for two years when prices were at $100 a barrel.
The makers of the Saudi oil policy have a very bitter memory of the failed effort in the early eighties to defend the prices at which economic oil was produced outside the OPEC countries. Since 1982 the member countries reduced their production to defend high prices only after the second price shock following the crisis in Iran between 1979 and 1981. Prices reached more than $100 a barrel In today dollars. Between 1982 and 1985, OPEC reduced its production by half, from 30 to 15 million barrels per day. Saudi Arabia took the bulk of the decrease, cutting production by 80%, from 10 to 2 million barrels per day. The failure of those policies became clear in 1985, and it only caused the reserves in the Gulf of Campeche in Mexico and the North Sea between Britain and Norway to be developed at the expense of the production of OPEC and in particular Saudi Arabia. This country does not want to make the same mistake this time.
If Saudi Arabia is wrong about the price it targets to defend, and it is high enough that the production of non-conventional oil in the US can be sustained, the result could be very similar to the early eighties. And it should abandon the defense strategy for one of leaving the market to figure out where US production stops. And we must remember that this price is a moving target given the permanent increases in productivity in the development of non-conventional oil and oil production in the world in general.
In closing, it is important to remember that, unlike the situation in Campeche and the North Sea, where reserves were finite and have been depleted, the reserves of non-conventional crude in the United States are considered essentially endless. In this model of the international oil market, the cost of production of non-conventional crude in the United States sets the global ceiling price of oil.