Two years ago, when the Organization of Petroleum Exporting Countries chose not to cut output and let oil prices collapse, many pundits penned obituaries for the producer roup. Yet on Wednesday, OPEC seemed to breathe new life, agreeing to cut output 1.2 million barrels per day (bpd).
While OPEC may have been hibernating, the decision by Saudi Arabia, OPEC’s leading member, to let oil prices crash was always a pragmatic one, not an ideological one. OPEC has sent stark reminder that when circumstances change, it can change too -- and it would be foolish to write off OPEC as irrelevant.
In November 2014, US shale oil output had been rising annually by around 1 million bpd, a stunning rate of growth. High and stable prices had pushed hundreds of billions of dollars into developing high cost sources of supply from the Arctic to the ultra-deepwater to the oil sands.
Iran had seen its oil exports fall from 2.4 million bpd in 2011 to less than 1 million bpd in 2013, and was expected to ramp back up once an agreement was reached to begin lifting sanctions. Moreover, most other OPEC countries, as well as non-OPEC ones like Mexico and Russia, signaled they would not join in any credible production cut and would let Saudi Arabia do all the work.
The Saudis had seen this movie before. In the 1980s, Oil Minister Yamani slashed output to support prices, resulting in reduced market share and export volumes that took years to recover. Regarded as one of Saudi Arabia’s most costly errors in oil market management, it is one that the Kingdom did not wish to repeat.
In addition to all these challenges, it seems clear in retrospect that Saudi Arabia misjudged how the United States and other producers would respond. US shale oil production was expected to collapse with lower prices. It was also assumed by many that longer-cycle high-cost producers would soon begin slowing. Moreover, the slowdown in oil demand growth in late 2014, led by China, caught many, including the Saudis, by surprise.
There is likely a geopolitical element to all this as well. Relations between Saudi Arabia and Iran, which have long vied to be the region’s leader, are at a low point. At a time when Iran was struggling to return to the oil market, Saudi Arabia was not inclined to make that easier by propping up prices and potentially ceding market share to Tehran.
The oil market today looks quite different than it did two years ago. Importantly, so does the economic situation within OPEC countries, including Saudi Arabia.
Nearly $1 trillion in capital investment in global oil and gas has been cut or delayed, according to Wood Mackenzie. US shale oil production has fallen and access to cheap debt is reduced. Iranian oil production is back to near pre-sanctions levels.
Moreover, OPEC and non-OPEC oil producers are facing severe economic pressure and budget shortfalls, increasing the urgency of pumping up prices.
While Saudi Arabia was better buttressed than others by its $750 billion in reserves in 2014, it is not immune. The Saudi economy has slowed sharply and concerns of recession abound, especially in the non-oil sector. The government has cut salaries and benefits, raised energy prices, and is seeking other sources of non-oil revenue, but popular discontent with these austerity measures is rising.
Riyadh has undertaken an ambitious and laudable economic reform program to diversify its economy but it will take years to implement. And while low oil prices were a catalyst for reform, they also make implementing reform more difficult by weakening the non-oil sector of the economy and hampering foreign investment.
US shale oil remains a complicating factor. While production has declined about 1 million bpd from its April 2015 peak, the industry has become remarkably more efficient. The Dallas Federal Reserve estimates that the breakeven cost of US shale has fallen from $79 per barrel in 2014 to $53 today.
While there remains uncertainty, it is increasingly evident US shale can rebound sharply when prices recover. Just how quickly it returns and how quickly global demand grows will determine whether OPEC’s decision to cut output maximises its revenue through higher prices or just losing market share to US suppliers.
Both the magnitude and shorter time cycles of US shale oil are now acting as significant new constraints on OPEC’s ability control oil prices and the producer group may not have the power long feared following the Arab Oil Embargo of 1973 to manipulate oil prices.
Saudi Arabia holds little spare oil production capacity to tap when oil prices spike. It has made clear that it has no interest in being the swing supplier to prop up low prices resulting from structural market forces.
But the agreement in Vienna is a reminder that OPEC collective action is still possible when producers see opportunities and favorable circumstances to boost revenue. In addition, looking beyond 2020, significant new OPEC supplies will yet be needed to meet higher demand.
OPEC may not be controlling the oil market the way it once did, but reports of its death were greatly exaggerated.