OPEC is the reason many thought oil price wouldn’t drop below $85. For the US, OPEC’s main supplier is Saudi Arabia, and the Saudi budget was based on an oil price of $88. The conventional wisdom was that if price will drop, OPEC will produce less and raise it back to $88.
The key mistake in this conventional wisdom is the assumption that in the world of shale, price will increase if OPEC supply decreases. Simply put, shale is too big for OPEC.
Even if OPEC completely shuts down oil export to the US, more oil will be supplied to the US today than in 2010.
OPEC has two choices, it can either accept the shale all-in cost as price (say $65) or cut back capacity to increase price. To get prices back to pre-shale levels (say $90), OPEC needs to cut back about the same quantity that shale will produce at $90. However, at this price, the US and Canada shale projects produce more barrels a day (5-7 million) than the US ever imported from OPEC (~4.5 million). Cutting production any less is unlikely to affect price much as more shale producers will make up the difference.
This isn’t just theory. OPEC already cut US supply by 40%, with no effect on price! OPEC today provides the US only 2.7MBD, a 40% decrease from 2010 and prices are as low as ever. The dotted line in the 2015 figure shows this.
As long as shale oil is abundant and produced by competitive firms, OPEC cannot cause oil price to exceed shale’s all-in price. Any capacity OPEC will take out of the US market will be filled by shale producers. Instead, OPEC (and investors) should accept this as the price ceiling.
Repeat: With the current scale of shale, OPEC cannot profitably cause oil price to increase.
The next table illustrates possible long-term options for OPEC.1 While it is clear everyone in OPEC prefers the no-shale, $90+ a barrel world, among the relevant options today, cutting back production to raise prices is probably the least likely.
|Long Run Scenario||OPEC Quantity (MBD)||OPEC Cost ($/barrel)||Price||OPEC daily profit (Million US\$)|
|2010 (no shale)||4.5|
|With shale, OPEC at 2010 quantity||4.5|
|With shale and no OPEC production||0|
|With shale and smaller OPEC production||2.5|
|With shale and larger OPEC production||6|
Some readers may question the use of $65 as the price per barrel, and not the more recent $45. However, even in the short term, OPEC can hardly gain from decreasing production:
|Short Run Option||OPEC Quantity (MBD)||OPEC Cost ($/barrel)||Price||OPEC daily profit (Million US\$)|
If these numbers are right, OPEC is better off increasing quantity, even in the short term. How likely are these numbers? The most important numbers are the expected price if OPEC decreases or increases its quantity. At $\$35$, most shale production will halt nearly instantly. Therefore, OPEC can expect to sell its increased quantities at a price of at least $35. On the other hand, given the abundance of shale at around $65, expecting prices to surpass $70 for prolonged periods defies basic economics.
Therefore, even in the short term, OPEC is unlikely to lose from returning to 2010 quantities in the US market and is very likely to lose from cutting quantities back at all.
As mentioned above, OPEC did decrease its quantities to the US, as summarized in the following figure.
Three members: Nigeria, Algeria, and Angola, effectively stopped exporting to the US. Saudi Arabia, Ecuador, and Kuwait, effectively did not react. The main decrease in Saudi exports to the US was at the end of the previous decade, predating any price drop.
This imbalance in the reaction to shale may reflect some disagreement within OPEC on the best course of action, increased demand from China, or other, more involved considerations. In any case, the drastic cut had no effect on prices.
To summarize this part: In a world with shale oil, OPEC cannot, and should not, attempt to increase oil prices above shale’s all-in price by decreasing production. OPEC should accept shale as the marginal producer and it’s all-in cost as the future price and adjust it’s quantities accordingly. Committing to current production levels, and even increasing them, will stabilize the shale production segment at realistic levels and this should be OPEC’s main goal.
Oil 2016 Expectations
- These are illustrative numbers. I have no information about the actual numbers or options OPEC is considering. ↩