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Oil 2014-2016: OPEC seeking the optimal price

8 January 2017, Wealtheon

Oil was a major feature of 2016. During February the WTI oil price (New-York) fell below USD 27 per barrel, whereas it had been trading at over USD 100 eighteen months earlier. The steep fall in the price contributed strongly to the deflationary tensions weighing on the global economy, which have been one of the major preoccupations for the central banks over the past two years.

The OPEC pump-at-will policy during 2014

Although the slowdown in Chinese economic growth and the development of non-conventional production methods triggered the fall in the oil price during 2014, the major impact came from the OPEC[1] decision at its meeting on 27 November to no longer support prices. Pressure was exacerbated by unofficial comments from the former Saudi Arabian energy minister evoking the possibility of the barrel falling to USD 20[2], which established a new psychological floor price level. The market, which was more or less used to OPEC supporting crude prices since its creation in 1960, subsequently lost all bearings. Analysts at several major banks saw crude prices on the verge of collapsing and priced-into their research the possibility of the oil price reaching USD 20[3].

Led to a collapse in the oil price to USD 20 per barrel

Figure n°1 above demonstrates the complexity of crude price formation. Economic growth, which is theoretically the core factor determining global oil demand, is the primary reference for the OPEC supply adjustment policy. As supply from non-OPEC countries is by definition always at its maximum level, OPEC assumes the responsibility of adjusting its output to the market. On the other hand, the maximum production costs for non-OPEC countries set the threshold below which output costs are no longer covered by revenues. Therefore, it is not the average cost which determines the floor price, but the highest oil costs. However, if OPEC no longer supports prices by producing a record level of output (see Fig.2), prices slide towards the non-OPEC supply marginal production cost, gradually eroding the profitability of the most expensive oil production sites, until they are priced out of the market.

Strengthened OPEC in its role as dominant producer

Shale oil production in the US therefore fell from 6 million barrels per day (Mbd) in 2014 to 5 Mbd at the end of 2016, revealing a profitability threshold of USD 50 - 60 per barrel. According to the International Energy Agency (IEA), oil majors slashed upstream oil capex by 25% in 2015 and a further 16% in 2016. The majors halted production at oil sites with the highest production costs, such as the Russian Arctic region (USD 120[4]), Canadian tar sands (USD 90), Brazilian offshore fields (USD 80), Angola (USD 40) and US deep-sea drilling (USD 57). This price war policy thus enabled the dominant producer to capture key information relating to the real production costs of its competitors. With a total of over 1,200 billion barrels, OPEC harbours around 70% of the proven global oil reserves which are the cheapest to produce. The pump-at-will policy will have enabled OPEC to demonstrate its ability to dictate pricing and reinforced its position as the global supply regulator.

Saudi Arabia does not wish to maintain a long term pump-at-will policy

Saudi Arabia is the leader of OPEC, supplying over 10 Mbd to the market, i.e. more than one third of OPEC production, at a minimal production cost estimated at around USD 3 per barrel[4]. Although its “comparative advantages” are sufficiently strong to enable Saudi Arabia to durably undercut prices, it did not seem to wish to use this option over the long term, given the pressures from various sources which would have been untenable:

  • Pressure from other OPEC member countries, with lower currency reserves than Saudi Arabia, for which a barrel of oil at USD 20 is not sustainable. Oil accounts form more than 50% of revenues generated by Iraq, Iran, Angola, Algeria, Kazakhstan and Venezuela, which have all been struggling economically and politically;
  • Pressure from the Arab world, where Saudi Arabia’s status as political and religious leader is becoming increasingly contested with the rise in Shia influence, as Iran comes back onto the international scene;
  • International pressure from Russia and also from the US and Europe, which were counting respectively on shale oil exploitation and North Sea production to diversify their supply sources;
  • Increasingly critical pressure from the West regarding the country’s domestic policies.
  • Internal pressures associated with the deteriorating finances of a high-spending country. Saudi Arabia has recorded record budget deficits over the past three years and the collapse in the oil price has eroded its deep currency reserves, which fell from from USD 740 billion at the end of November 2014 to 534 billion at the end of October 2016[5].

Which led to the Vienna agreement on 30 November 2016

The Vienna agreement on 30 November involves a 1.2 million barrel reduction in daily output by OPEC. The deal was expected as it suited all of the OPEC countries and also because Saudi Arabia needs the support of OPEC to increase its international influence (by ensuring OPEC leadership, Saudi Arabia has multiplied its capacity to influence the market threefold). Regarding the question as to whether the agreement will be respected, the real difficulty lies not with Iran, but with Iraq, another Shia majority country which produces “only” 4.2 Mbd but which has the greatest output potential, estimated at 9 Mbd. Iraq has never applied quotas, even under the leadership of Saddam Hussein.

It is interesting to note that the Vienna agreement was reached only three weeks after the election of Donald Trump as US president. During his campaign, Donald Trump referred several times to Ronald Reagan’s old dream of US energy independency. An agreement establishing the oil price in a range of USD 50 - 60 per barrel should enable the US to increase its energy independency via higher investments in shale oil and offshore exploitation. A rising oil price trend will also contribute to reflation, which should provide the central banks with some breathing space in 2017.

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[1] OPEC: Organisation of petroleum exporting countries

[2] Ali-al-Naimi at OPEC's headquarters in Vienna November 27, 2014: "Whether it goes down to $20, $40, $50, $60, it is irrelevant"

[3] Jeffrey Currie - Goldman Sachs Global Commodities Research Chief - Sep. 11 2015: “Oil prices are on the verge of plunging to $20 per barrel”

[4] Cost production estimates per country – World Bank Commodity Private data, January 2016

[5] Bloomberg data - Saudi Arabia Reserve Assets Index & Saudi Arabia Budget Deficit or Surplus to GDP Index


Macroeconomics


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