Woe-PEC: The cartel’s troubles continue, even after a deal is struck

It seems that no proposed corporate merger escapes the heavy scrutiny of antitrust regulators anymore.  Indeed, more and more, we see companies themselves suing one another over anticompetitive practices.  Given these trends, wouldn’t you be surprised to hear that the world’s largest cartel gets away scot-free with the deliberate manipulation of markets?

This is, of course, because the world’s largest cartel is OPEC.  The Organisation of the Petroleum Exporting Countries, as it is called in full, consists of 13 member states from across South America, Africa, and the Middle East.  Because it is an organisation of nations, OPEC sits outside the jurisdiction of antitrust laws.  Their production decisions are considered “governmental acts of state” as opposed to commercial manipulation of markets.

In 2015, OPEC states collectively produced over 40% of the world’s oil and possessed almost three-quarters of its proven reserves.  This means that when it’s members get together to act in a coordinated fashion, the impacts reverberate around the world.

For most of 2016, all eyes were glued on the Kingdom of Saudi Arabia, the largest producer in the cartel, as the Saudis sought to broker the first deal among OPEC members in several years.  The aim of the new deal was to get members to agree to curb their oil production and, consequently, induce an increase in the global price of oil.

The rationale for a deal was clear. Oil exporters have been feeling the pain in the last two years following a plunge in the oil price from well above $100 per barrel to as low as $30 in early 2016.  Prolonged low prices have forced action by nations such as Saudi Arabia, which depend on oil revenues to fund their state budgets. 

West Texas Intermediate crude oil price (USD per barrel)

When negotiations finally concluded on November 30th last year, OPEC members had agreed to cut their production by 1.2M barrels of oil per day. This cut amounted to approximately ~1.5% of global production. Saudi Arabia carried the brunt of the load, pledging to constrict supply by 500,000 barrels per day.  By mid-December, another deal had been struck with a group of non-OPEC members, including Russia, to cut production by a further 600,000 barrels per day.  To make that figure real for you, the combined 1.8M barrels per day of cut production would be enough to fill Wembley Stadium to the brim, once every four days.

On the day of the first deal, the WTI crude price opened at $47.07 and closed at $51.21.  By the time the additional deal was struck, prices had risen to over $54, where they have roughly stayed up until the publication of this article.  Besides some grumbling about members cheating their quotas (as has happened with past deals), it is not clear that the increase was everything OPEC had hoped for.  The Emirati Energy Minister was quoted as saying that $50 oil “isn’t going to cut it.”  This is no surprise, as the IMF has estimated the UAE to require a price of at least $60 in order to balance the country’s budget.

One major reason for tempered enthusiasm is that today, unlike in past OPEC deals, the cartel must contend with a new dynamic – the highly flexible, low cost shale producers which have been reportedly mobilizing across the United States. While the onshore oil rig count in the United States plunged alongside the oil price, American producers did not sit idle.  Major advances in the productivity and efficiency of onshore wells meant that while the number of onshore oil rigs dropped from around 1,500 in late 2014 to only 530 today, U.S. onshore crude output decreased by only 6%.  Rig operations today are bigger, faster, and critically – more flexible to capitalize on short term changes in the oil price.

The current consensus is that U.S. oil and gas capital spending is posed to increase dramatically in 2017, bringing with it a significant increase in output.  The United States’ Energy Information Administration (EIA) recently revised their forecast for U.S. production in 2017.  Where they had previously been calling for a decrease in overall output, they now expect an increase of 1.3%, or roughly 100,000-120,000 barrels per day.  They project that even with the significant cuts made by OPEC, global production of oil this year will continue to outstrip demand by an estimated 330,000 barrels per day – further increasing the already sizeable build-up of on-surface oil inventories.  The downward pressure these inventories put on the oil price could worsen in 2018.  The EIA expects an uptick in investment today to translate into a further increase of 300,000 barrels per day next year, in the U.S. alone.

Another important contributor to the optimistic attitude in U.S. oil is the appointment of Rex Tillerson, former chief of ExxonMobil, as U.S. Secretary of State.  Many see this as a potential boon for American oilmen.

None of this is good news for OPEC and their partners. We could very well see the new agreements unravel if the 1.8M barrels per day being pulled off the market are simply replaced by American product, with the effect of capping or even depressing the price they worked so hard to prop up.  Up against a re-emergent U.S. oil industry and a new protectionist administration, OPEC had better hope they haven’t played their Trump card too soon.

February 1, 2017 by: Andrew Dean, MBA2018