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Opec must decide between market share and oil price

The legacy of Opec’s high oil-price strategy is now plain: rising supply and weakening demand growth. The group must decide whether to rescue its market share or the oil price

Some time on 27 November, probably in the late afternoon, Abdalla El-Badri will sit down behind a microphone in a windowless basement room in Vienna and tell the world how Opec plans to deal with an oil price that, by Petroleum Economist’s press time, had lost a quarter of its value since early June. If the downward trend lasts, the group’s basket of crude could be trading well beneath $80 a barrel by the time the secretary general speaks. Will his words matter?

Opec claims to hold 81% of the world’s conventional crude-oil reserves and produces a third of its oil. So there are good reasons why journalists gather twice a year in the Austrian capital to stalk oil ministers from the cartel’s 12 member states –and why traders await their first news flashes. Yet Opec is in trouble and this meeting will be different.

Opec is divided into two camps: the won’t cuts and the can’t cuts. In the first category is Saudi Arabia, supported by the other Gulf Cooperation Council countries in Opec. They’ve spent the past few weeks signalling that they will let the market drift lower, possibly, as Bill Farren-Price reveals in one of the articles in Petroleum Economist’s Opec survey this month, to remind the rest of the group that when and if a cut comes, the rest of the group must join in too.

Then there’s the rest, a collection of producers marred by economic mismanagement, internal conflict, sanctions or geological decline – or some combination of them – that have neither the financial or political capacity to pull back their own production.

That doesn’t mean that this second group won’t plead for Saudi Arabia to withhold some supply to help them out. The ever-hawkish Venezuela has already called for an extraordinary meeting to halt the slide. If prices drop more steeply in the weeks before the meeting – and rumours of a large rise in Opec exports for November suggest this is possible – their argument may even carry the day.

Even if it does, though, Opec would risk a big blunder by trying to prop up prices. Its market share is in rapid decline. If fewer people are buying what you sell, then raising its price won’t help you. Three years ago, the call on its crude was 30m barrels a day (b/d). Next year, says the International Energy Agency (IEA), it will fall to 29.3m b/d, a third consecutive year-on-year fall. In the same period, global oil demand has risen from 88.9m to 92.4m b/d, meaning that in just three years Opec’s share of the market has fallen by two percentage points, to 31.7%.

The threat of losing market share didn’t stop Opec cutting hard in November and December 2008, when it removed 4.2m b/d from the market – an unprecedented move that dragged oil prices off the floor and sent them on their way to $100/b. Opec knew that as prices rose in the years after it could lift output and regain its customers.

Three things happened between then and now. Political chaos across the Middle East and parts of Africa stripped yet more supply, much of it Opec’s, from the market. By contrast, US tight oil, finally viable thanks to the sustained rally in prices, took off. The killer statistics are these: between January 2011 and July 2014, disruptions to Opec supply rose by 3m b/d, according to Citibank. In the same period, non-Opec supply rose by more (see Figure 1). In other words, tight oil did what Opec could not: it kept the market balanced.

Now, too, geopolitical risk has switched from being a source of strength for oil prices to one of weakness. The market has priced in the supply disruptions and the threat of ones that could happen. The risk today is on the upside for supply: that Libya is able to maintain output despite internal chaos; that Iraq’s production keeps growing; or that sanctions on Iran are lifted.

The third factor was demand. This year, the world’s ailing economy will consume only 0.7m b/d more than it did last year, according to the IEA – a shocking number for the global oil sector. Poor growth prospects in the eurozone and a slow-down in consumption growth in Asia are to blame. But longer-term trends are becoming visible, too. Ever-higher fuel economy standards, greater efficiencies in engines, a transition in advanced economies away from commuter car-dependent lifestyles, the rise of faster telecommunications and of alternative fuels, including electrification and gasification of transport, are all chipping away at oil.

Some of the shifts are cultural, behavioural ones. But an era of high oil prices has accelerated the trend. Oil demand growth may pick up speed next year as the world economy improves, believe the forecasters. But the line of the graph will not rise as steeply as it did in years past.
In those conditions, of softer demand growth and fast-rising supply, any move by Opec to defend the price would risk the double whammy of losing more market share while also putting more momentum behind the very forces that have been behind the declining call on its oil.

Bottom out

But the alternative, to let the market find its bottom, is risky too, because its logic is speculative. One argument is that a decline in the price will hit expensive marginal production from North America, winning back customers for Opec’s lower-cost producers. It might also perk up demand. For the West African members, who have seen tight oil push their light crude into an over-supplied Atlantic basin, it sounds wonderful.

In reality, this depends on how North American unconventional oil reacts to lower prices. Shares in US-listed energy players have performed badly since the oil price began sinking, which should translate into less funding for upstream activity. In terms of break-even production costs, however, the picture isn’t so clear. The IEA says only 4% of US tight-oil supply needs an oil price of more than $80/b to turn a profit. Other studies show that growth in tight-oil output will slow, but not cease. Much of US tight-oil output breaks even below $50/b, and this is falling – not least because many big costs, such as land acquisition, have been sunken, and well productivity is improving. Some future Canadian oil sands output is vulnerable at $80/b, but Canadian bitumen production will continue to rise. By 2018, a new pipeline will take some of it to the Atlantic basin, too. 

In any event, a price-related haircut for some of North America’s marginal barrels could help sustain its industry, not kill it. In Alberta, labour tightness would ease if some of the costlier projects were shelved. In the US, a drop in rig activity would drive down costs by forcing more competition on the services sector. A free market can react in ways that might surprise Opec, whose state companies have added nothing like the same productive capacity during the boom years. It would also take time to clear out some of the supply abundance that has loosened the market.

Back in 2012, in a paper for Harvard’s Belfer Center, Leonardo Maugeri argued that if prices remained above $70/b for long enough, then upstream investment would yield sustained output growth and overproduction by 2015. Eventually, he said, the costs of this oil would fall and the new production would be cushioned from a price drop. The result would be a glut. His vision, maligned by many tight oil sceptics, now looks uncomfortably close for Opec.

As Petroleum Economist’s survey this month shows, all this leaves the group in a dangerous spot. But don’t believe the rumours of its demise. It survived the early 1980s, when demand crashed, North Sea and Alaskan production surged, Saudi Arabia’s output plunged from 10m to 3.4m b/d, and oil prices struggled to stay above $10/b.

Unbalanced economy

By comparison, oil prices remain historically high. Although too many of Opec’s members now depend on triple-digit oil prices to keep their inflated budgets and sclerotic economies afloat, the wiser ones in the Gulf have amassed foreign currency reserves that will see them through a revenue hit.

For the others, a correction is in order. Opec must decide whether to continue seeing maximum revenue from each barrel, or begin a long-term strategy to regain market share. If $100 oil prices come back, the group must be prepared for the unconventional bonanza to keep spreading – Argentina, China and Russia all hope to be next in the queue – and for the advent of peak demand. If a market share grab is about to begin, the group will have to accept the role of price-taker, not price-setter. Opec has often dictated terms to the oil market. For the time being, the oil market is dictating back. 

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