OPEC’s $900 Billion Mistake
By Euan Marns
Posted on Mon, 24 August 2015 19:59 | 9 With WTI falling below $40 and perhaps heading for $20, one needs to wonder ifOPEC’s strategy is working out as planned? Why are they following this course and what are their goals? The face value explanation, accepted by many, is that OPEC is protecting market share especially against rampant supply growth in the OECD, namely in the US LTO (light tight oil) patch. This post examines how OPEC’s market share has evolved with time and with past swings in the oil price.
This turned out to be more complex than expected. But scrutiny of the data shows that following each of the three oil shocks since 1965 (Figure 1) OPEC market share AND oil price fell (Figure 3). The most recent trend follows the 2008-2014 highs and I believe it is this observation that is driving current behaviour.
Had OPEC decided to sacrifice about 5% market share they could have maintained price above $100 per barrel for years to come in which time the US shale bonanza may have burned out. It seems that OPEC may have made a colossal error that threatens to de-stabilize their member countries.
Figure 1 OPEC market share is simply OPEC production / global production. It is very difficult to make sense of the data from this plot. In Figure 2 the variables are cross plotted against each other which does enable some sense to be made. Shock 1 = Yom Kippur, Shock 2 = Iranian revolution and Shock 3 = peak cheap conventional oil.
Figure 2 This chart cross plots the two variables shown in Figure 1. It should be obvious that there is no overall correlation between OPEC market share and price. The chart is a time series that needs to be read in a counter clockwise direction beginning in 1965. The arrow 2014 to today is conceptual since I do not have the BP C+C+NGL YTD data available. The arrow shows a very slight increase in OPEC share since their production has risen this year. The trends are summarized in Figure 3. The picture is clouded by the 2008/09 crash. These years are labelled 08 (8) to 14 (4). See text for further details.
Cross plotting market share against price produces a curious pattern which is a time series that describes different market behavior for different time segments (Figures 2 and 3). To read the plot you have to begin in 1965 and work your way around in a counter clockwise direction. Note that by 1992-2003 the market had almost gone full circle.
The period 1965 to 2003 is marked by two major events – the Yom Kippur war and the Iranian revolution that was followed by the Iran-Iraq war. Combined, these two shocks sent the oil price over $100 / bbl. The period 1979 to 2003 may be viewed as one of relaxation and adjustment back to the starting point. Post 2003 a new ball game began with a plateau in cheap conventional oil production. Using pre-2003 behavior to predict what might happen now is likely a major mistake!
OPEC’s market share has varied enormously from a high of 51.2% in 1973 that coincided with low price and a low of 27.6% in 1985 that coincided with an intermediate price of $60 / bbl.
Figure 3 Summary of the trends evident in Figure 2.
There are three periods when OPEC enjoyed rising market share. The first, 1965 to 1973 had essentially flat prices. The second, 1985 to 1992 saw market share rising against a backdrop of falling price. The third, 2004 to 2014 saw OPEC market share increase marginally against a backdrop of rapidly rising prices.
The three cycles of rising market share are cancelled by three cycles of falling market share AND falling price. Each of these cycles occur after oil price shocks and OPEC therefore found itself in the early stage of such a cycle in 2014.
If one looks at prior falling share cycles, 1974 to 1978 was not that bad for OPEC. They lost 5% market share and the oil price shed $5. The second falling share cycle, 1979 to 1985, saw market share fall 18% (39% in relative terms) and price fall by $45. This was truly a bad period for OPEC and I dare say it is this that Saudi Arabia wants to avoid this time. This period also witnessed global oil demand in decline as the global economy adjusted to the sharply higher oil price. Hence at this time OPEC were getting a smaller share of a smaller pie. The third falling share cycle, 2008-2014 has seen market share fall a trivial 2.5% and price fall about $8 from record highs. And in this period most OPEC countries have been pumping at capacity and at record combined levels over 36 M bpd C+C+NGL. 2008-2014 has been an amazing pink patch for OPEC, too good to be true and too good to last.
Have OPEC just made a gigantic blunder?
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Has the current OPEC strategy of flooding the market with their cheap oil turned out as planned or has it turned into a gigantic blunder? Figure 4 shows schematically three scenarios and alternative courses that may have been followed. The first is where we were heading. With the flood of oil that has come to market in 2015 combined with weak demand it is likely that OPEC would have had to cut production incrementally to have maintained the trajectory of slowly falling share and price. Scenario 2 shows what might have happened with a continuation of recent policy of supporting price. Trimming 4 M bpd from production (5% share) incrementally may have maintained prices of $100 / bbl. Scenario 3 shows what has come to pass and where we are heading.
Figure 4 Three conceptual scenarios for different courses of action that OPEC may have followed.
I think it is safe to presume that, with the benefit of hindsight, OPEC’s preference would be within the vicinity of the 2008-2014 cluster. At present it therefore looks like OPEC have made a gigantic blunder. Their actions can only be vindicated if they do manage to break the back of the US LTO producers and other OECD and non-OECD producers like Gazprom and to some time soon end up with significantly increased share and price. Since OPEC is already pumping flat out, the only way to significantly increase share is if global production falls. This would herald another global recession since GDP and oil consumption are generally correlated.
Had OPEC pursued option 2 they may have benefited from unpredictable global events working in their favor. In choosing option 3 they now appear to have elected economic suicide for many members. I’m sure that was not the intention.
What happens next? I believe that OPEC and Russia will hang tough for a while yet, until at least US oil linked debts are re-determined at the end of the third quarter. The outcome of that is in itself uncertain. While most predict a blood bath in the LTO patch, and I am not disagreeing that this is likely, strategic events are unpredictable. There is much hubris involved on both sides. Will the USA really sit back and watch its shale industry get kicked into the long grass?
Near term I think it likely we see WTI flirt with $20 and Brent below $30. At that point the global oil industry will be on its knees, including OPEC, the OECD and Russia. Russia may then either join or form an alliance with OPEC and we then see production cuts, incrementally up to 4 Mbpd and the price rise back towards that magic $100 / bbl number. I think it is safe to say that the oil industry and global economy are equally focused on stability as they are price and many will be asking what was the point? Meanwhile, in an increasingly meta-stable world, events may sweep all this into oblivion.
Finally, a concluding thought. Had OPEC defended price as opposed to share they may have seen production fall by 5 M bpd and a price close to $100 maintained. The current course of defending 36 M bpd may take the oil price down to $20.
32 M bpd @ $100 is worth $1168 billion per year
36 M bpd @ $20 is worth $263 billion per year
The difference of $905 billion per year could make this one of the costliest blunders of all time.
Figure 5 The notional value of OPEC production calculated by multiplying daily production by price by 365.
By Euan Mearns