23 Feb 2016

Long term trouble for OPEC

Jori writes*

Although the recent fall of oil prices caught most of the world by surprise, soon a simple narrative emerged as to what was going on. Global demand is low, American shale has increased supply, prices fall. OPEC’s decision not to cut production neatly fell into this: the traditional oil producing countries are threatened by competition from the relatively expensive to produce shale oil, but sticking to low prices will destroy the American shale-industry and make the world return to the old status quo. The current price of a barrel of West Texas Intermediate is around $29, while the average production cost in America is $36.20. In countries like Saudi Arabia the cost is only $9.90, meaning it seems like production there can whether the storm unlike in the USA. Some of this scenario is indeed playing out: after years of growth, American crude oil production is very likely to decline in 2016 because many wells are no longer viable. Does this mean Saudi dominance, OPEC’s control of the oil market and high prices will soon return?

One of the big problems that is often pointed out about this story is that although production is still profitable in many OPEC countries, (unlike foreign competition) the whole state is practically built on redistributing oil rent. A bad year of American shale means bankruptcy and unemployment, sure. The risks for OPEC countries are a lot greater however, because it could undermine the legitimacy of the entire regime.

Even if OPEC survives these low prices and American production nosedives, it is vital to this narrative that competition is destroyed for good. In other words, it assumes inelasticity of supply after its gone down. This is very questionable. The economics of shale are very different from traditional sources of oil because although might not be as cheap to produce, “production can be turned on and off much more easily.” This means production will be more responsive to price signals than previous competitors. On top of this are America’s bankruptcy laws and and financial institutions which ensure that even if this generation of drillers goes bust, as soon as prices rise the next generation can step in to to scoop up their assets. All of this combined seems to point to, unlike before, market mechanisms instead of OPEC will be playing a role large in setting prices. Low prices now might not be not as detrimental to American production in the long run as often assumed.

This does not mean OPEC is definitely broken for good. The International Energy Agency has expressed skepticism over the the ability of American industry to remobilize and “argues that banks may be reluctant to fund more of their wells.” However, when betting on either the power of one of the last world’s global cartels or the market and the desire of a new cohort of entrepreneurs looking for profits, my money would be on the latter.

Bottom Line Although lower oil prices hurt American production, but because the shale industry has a higher elasticity of supply than traditional oil sources (both because of institutional and technological reasons) OPEC might not regain its market power.

* Please comment on these posts from my microeconomics students, to help them with unclear analysis, other perspectives, data sources, etc.


Robert Pyke said...

It turns out that the US shale oil producers are much more flexible and innovative than the Saudis expected and that, while new wells are way down, many operators are managing ok by reworking existing fracs and focusing on the better prospects. By the time new wells are really needed the price will have gone up in order to keep the KSA and others in business. See numerous articles on OILPRO.com

Brian Cassee said...

Nice analysis. I incidentally also wrote my blogpost about oil prices and OPEC. Keep in mind that the Saudis are suffering from a deficit. One that is being worsened by this oil shock. They will still have to suffer immensely (financially) to eliminate competitors. Additionally, consider the narrative that perhaps America is even encouraging this level of production. Primarily because it challenges the Russian economy in a form of economic warfare. And the USA clearly has an interest in such an outcome. I think the main question is who is battling with who?

Simon Toussaint said...

I agree with Brian: I think Saudi Arabia is not (only) targeting US shale producers with their current level of production, but also chief rivals like Russia (and perhaps Venezuela). Related to this is another, very interesting dimension: it is quite plausible that Saudi Arabia, with an eye on Iran's imminent reentry in the global markets, wants to target that economy especially.
Finally, regarding the viability of the OPEC's strategy: I agree that their strategy probably will not endure, but it is incomplete to only look at the relative prices of oil production. Saudi Arabia can also afford to do this thanks to their enormous currency reserves. These reserves are rapidly evaporating because of the low oil price, but this remains another factor to determine their strategy's viability.

Very good blog post!

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