Last week’s OPEC deal takes place in a very different context than earlier deals from the 1990s, writes Geoffrey Styles, Managing Director of independent US-based consultancy GSW Strategy Group. US shale producers are looking to fill supply gaps, inventories are higher than ever, and alternatives to oil in transport are emerging. If that’s not a recipe for volatility, Styles wonders, then what is? Original post.
From one perspective, the agreement struck by OPEC’s members in Vienna on 30 November marks the cartel’s return to the business of managing the oil market, after a two-year experiment with the free market. Viewed another way, however, it represents what Bloomberg’s Liam Denning termed a “capitulation of sorts“–an admission of defeat in the price war that OPEC effectively declared in late 2014. Yet while more than a few bottles of champagne were likely consumed around the US oil patch, this doesn’t necessarily mean a return to the way things were just a few years ago, when oil prices seemed to cycle between high and higher.
We should look carefully to assess the real results of OPEC’s attempt to squeeze higher-cost producers out of the market. On that criterion it was successful: hundreds of billions of dollars in oil exploration and production projects have been canceled or deferred, mainly by Western oil companies and other non-OPEC producers. If this was the 1990s, and oil still lacked viable competition, especially in transportation, and if demand could be relied on to continue growing steadily, the strategy OPEC has just ended would have set up many years of strong and rising prices for its members.
Yet OPEC miscalculated in at least two ways. First, as many experts have noted, it correctly identified US shale producers as the new marginal suppliers to the market but failed to anticipate how quickly these companies could respond to a dramatic price cut. Having squeezed their vendors and spread best drilling practices at warp speed, shale producers are now positioned to resume growing both output and profits as oil prices trend north of $50 per barrel–undermining the effect of OPEC’s cuts as they go.
Its other miscalculation was in the capacity of the cartel’s members– even some of the strongest–to endure the austerity that protracted low prices would bring. Although many of these countries have among the world’s lowest-cost oil reserves to find and produce, it turned out that their effective cost structures, including transfers to their national budgets, were really no lower than those of the Western oil majors that have also struggled for the last two years.
A great deal of attention will now be focused on how OPEC implements its output cuts, and whether its non-OPEC partners like Russia live up to their end of the bargain. The history of OPEC deals suggests that is only prudent. However, a new factor is at work here that adds extra uncertainty to the outcome, even if OPEC miraculously achieved 100% compliance.
OPEC’s formula for sustaining comfortably high (for them) oil prices has always relied on an economic paradox: They restrain their own, low-cost production and shift the marginal source of supply – the last barrel that sets the price – to make room for non-OPEC producers with much higher costs. That allows OPEC’s members to collect outsize returns on their own production, what economists call “rent”.
This time, though, at least until the looming gap in supply created by all that foregone investment in deepwater platforms and oil sands facilities starts to bite, the cost of the marginal barrel from shale won’t be that much higher than OPEC’s marginal cost. And all of this will be playing out in the context of historically high inventories. If that’s not a recipe for volatility, I don’t know what is.
Geoffrey Styles is energy expert, advisor and communicator. He is Managing Director of GSW Strategy Group in Virginia, an energy and environmental strategy consulting firm helping organizations and executives address systems-level policy. This article was first published on his blog Energy Outlook and is republished here with permission.