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Pressure on Opec from weak demand and rising supplies

But these pressures are not for the first time. Robin Mills puts the latest crisis in context

As one prominent Saudi policymaker likes to observe, Opec is like a tea bag - it works best when in hot water. With Brent prices falling below $90 per barrel for the first time in two years, the water is certainly warming up. But, as Rockefeller would have put it, some Opec producers may be happy to give their colleagues and competitors a good sweating.

Opec's basket price, a more accurate reflection of the organisation's sales, is at its lowest since 2010, when prices were still staggering back from the global financial crisis. In 2008, oil prices had plunged briefly to $34/b and the group's shaken members responded with sharp production cuts that gradually reinflated the market. This year, weak Chinese oil demand growth - only half that of pre-2008 levels - and fears of recession in Germany are colliding with continued explosive expansion in US output and corresponding falls in oil imports.

Opec has not yet responded to the slump. September production reached a one-year high at 30.935 million barrels a day (b/d), as production recovered in Libya and gained in Iraq, while the core Gulf Opec producers kept output steady. But the organisation sees the call on its production at 29.2m b/d during 2015, implying the need for around 1.7m b/d of production cuts. This call may remain rather flat or decline slowly over the rest of the decade, leaving Opec members fighting over a shrinking cake, always the organisation's least pleasant tea party.

Saudi Arabia has three guests at this uncomfortable gathering. Its core Gulf allies of the United Arab Emirates (UAE) and Kuwait have generally followed its lead. But even Kuwait is competing for the key Asian market - it set October prices at $0.50/b below the Saudis' Arab Medium.

Then the core Gulf Opec countries have to contend against the organisation's fringe members, who generally produce close to capacity. That includes three members with plans to make major production gains: Libya, Iraq and Iran.

With Libya's political situation continuing to deteriorate, its recovery to around 0.9m b/d of production is a surprising - and fragile -achievement. Iraq's southern production has not yet been seriously affected by the fighting against the Islamic State in the north, but the potential remains for a general security deterioration. On the other hand, new oil minister Adel Abdel Mehdi appears to have a clear idea of tackling some of the industry's obstacles in bureaucracy and infrastructure.

Rising player

Iran could bring 1m b/d back to the table quite quickly, and make larger gains into the 2020s by bringing international investment to its giant under-developed fields. But that hinges on a deal in the nuclear negotiations, reaching a deadline on 24 November - with a further extension probably the most likely outcome.

Venezuela has been the first Opec member to find the water too hot for its liking, with President Nicolás Maduro instructing foreign minister (and until recently oil minister and head of national oil company PdV) Rafael Ramírez to call for an extraordinary Opec meeting. This was poor tactics from the Venezuelans: their panicked response will give the Saudis leverage to demand shared production cuts, should Riyadh deem that necessary. It is already obvious that they, along with Iran, are the Opec members most financially vulnerable to low oil prices - Citigroup estimates Caracas's break-even budget oil price to be $161/b and Tehran's at $130/b.

Other fiscally vulnerable members include Iraq, Algeria and Nigeria. On the other hand, Saudi Arabia's break-even budget price may be around $90/b but it could dip into giant sovereign wealth holdings, trim spending or take on modest amounts of debt. The long-term oil dependency of Saudi Arabia and its Gulf colleagues is deeply troubling, but they are well-placed to endure a brief heatwave.

And Opec has to play against non-Opec producers. The poor performance of non-Opec has been one of the key factors in the past decade's price boom, with sharp declines in the North Sea and Mexico accompanied by massive delays and cost overruns in new frontier projects, such as Kazakhstan's Kashagan. Frontier exploration has also been disappointing.

But over the past few years, North American shale, supported by Canadian oil sands, has been the shining counter-example, disproving claims that unconventional resources could not be brought to market quickly in large volumes. The US' Energy Information Administration (EIA) sees the US adding 1.1m b/d of production this year and 963,000 b/d in 2015.

Resilient rocks

Efficiency in shale drilling continues to advance, with rigs operating in Texas's Permian and Eagle Ford plays being 20% more productive than just a year ago. The idea that production growth would slow as so-called sweet spots were drilled up has not yet come to pass, as technology, improved operations and better understanding of shales outpaces depletion.

Opec may hope that lower prices will cool the shale oil boom. Clearly the fast decline rate and relatively high costs of shale should make it much more price-responsive than traditional, long lead-time oil projects.

However, consultants Wood Mackenzie estimated that 70% of US reserves would remain economic at an oil price of $75/b. Actually, shale may prove more robust still. A modest fall in activity, removing the marginal - and hence most service-intensive - production would reduce costs for everybody else, and ease congestion in transport routes. Lower prices may also make an end to the US crude export ban more palatable. Both the North Sea in the 1980s, and shale gas over the past few years, proved far more robust than most observers expected, even if producers appeared to be losing money.

The EIA's base-case expectation, that the shale boom will tail off around 2020, has given hope to some Opec observers that their production share will rise again in the next decade. The major players such as Shell and Total have already pre-emptively begun cutting back on spending. But it would be dangerous to count on another halt in non-Opec growth, with initial thoughts about enhanced oil recovery in shales hinting at further reserves from an enormous resource base.

Experiments in global shales outside North America have been patchy - sanctions may blunt a Russian shale oil boom - but Argentina's excellent geology is showing promise. Following its upstream reforms, Mexico - both in shale and deep water - should also be a significant factor. Opec members themselves - Algeria, Venezuela, perhaps Libya - are also venturing into unconventional oil, both shale and heavy oil, which may eventually make adherence to quotas tricky.

Opec would be wiser to plan for a long-term challenge from shale and other new oil sources. Perhaps even more importantly, displacement of oil demand by gas, by more efficient vehicles, ships and aeroplanes, and possibly in the 2020s by an expanding hybrid and electric vehicle fleet, are the all-too-predictable consequences of an attempt to keep prices too high, for too long.

Previous work by economists such as Dermot Gately has suggested that Opec's long-term revenue is maximised when it does no more than maintain market share. He used this observation to argue that large increases in Opec production and market share, such as those forecast by the EIA and the International Energy Agency a few years ago, were implausible. This puts the burden on non-Opec supply at least to keep pace with global demand growth - which it failed to do during 2003-08, but has managed since then.

Opec has, of course, been written off before. This is far from its worst political or market crisis. In 1980-88, two of its members, Iran and Iraq, were at war and had to be separated unalphabetically at meetings by the minister from Indonesia. In 1990-91, one member was occupied by another and its oil-wells set ablaze. In 1986 and again in 1998, prices slumped as the Saudis used price wars to try to impose some discipline. Now, Saudi Arabia and Iran are far from friendly but there have been some tentative moves towards rapprochement.

Opec can probably make production cuts to stabilise the price - for now. The key questions are: for how long will non-core Opec members adhere to those cuts? Can Iraq be brought back into the quota system if it manages to resume strong production growth? Would a returning Iran accept a reduction in its implied quota? These questions are particularly tricky given that Opec has for some time had only an overall ceiling, not formal quotas per member.

Most important of all: what oil price is Opec seeking to defend? Around $100/b was clearly too high, and sustained only for a year or two because of unanticipated crises in Libya and Iran. What price will allow robust demand growth while also moderating the rise of unconventional oil? With some adjustment, the core Gulf Opec members could tolerate, say, $80/b, but that would require painful adjustment for fringe Opec countries.

Price war woes

A renewed geopolitical crisis brought on by a fiscal squeeze in, say, Libya, Venezuela, Algeria or Nigeria, or even a non-Opec guest such as Russia, could interrupt supplies. None of these countries has the firepower to contemplate a price war. Nor could they imitate Iraq or 1990s Venezuela's apertura by aiming to use foreign investment to raise production sharply.

So Opec is shifting from tepid water into hot. In tepid water, as during 2003-08, the call on its production rose steadily, the Gulf countries took up the slack and the others kept up or lagged behind as best they could. Opec as a mechanism was hardly required. In hot water, the call on production falls, and the Saudis have to coerce everyone else to fall into line. In a sharp crisis, as in 1998 or 2009, the struggle is short-lived and Opec discipline cohesive. In a long crisis, as from 1986 onwards, boiling off the high-cost competition is a lengthy and painful process.

This latest price slump is nowhere near as precipitous as in 1986, and prices remain very high in historical terms. But an extended slack market means the Gulf Opec countries will have to inflict a good sweating on their colleagues, and endure the same themselves.

Robin Mills is head of consulting at Manaar Energy and author of The Myth of the Oil Crisis

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