- OPEC's unwillingness or inability to reduce output to defend high oil prices raises doubts about the cartel's effectiveness and future.
- Absent cuts by OPEC, it is not yet clear whether the burden of rebalancing oil markets will fall on shale production or larger, more traditional oil projects.
A quick review of OPEC's history of reining in production to prop up oil prices reflects a mixed record. At least three distinct episodes come to mind:
- Following the oil crises of the 1970s the cartel was unable to keep prices above $30 per barrel ($70 in today's money) in the face of surging output from the North Sea and North Slope, and a 10% decline in global oil demand from 1979-83. By summer 1986 oil had fallen to just over $10, despite Saudi Arabia's having cut production by up to 6.7 million bbl/day from 1981-85, along with the loss of another couple million bbl/day of supply due to the Iran/Iraq War. Aside from a spike prior to the Gulf War, oil was rarely much above $20 for the next two decades.
- OPEC's response to the Asian Economic Crisis of the late 1990s was more successful. When the growth of such "Asian Tigers" as Indonesia, Malaysia, Singapore, South Korea and Thailand stalled amid contagious currency crises, oil inventories swelled and prices collapsed from the mid-$20s to low teens and less. In March 1999 OPEC agreed to reduce output by around 2 million bbl/day, including voluntary cuts by Mexico, Norway and Russia. Although historical data raises doubts that the latter countries ever followed through on these commitments, this move stabilized prices and restored them to pre-crisis levels by year-end.
- After oil prices went into free fall during the financial crisis of 2008, OPEC's members agreed in late 2008 to cut over 4 million bbl/day. They apparently achieved around 75% of that figure. Together with the measures taken by central banks and governments to restore confidence, that was enough to boost oil prices from the low $40s to mid-$70s by late 2009, still well short of the $145 peak in June 2008.
The roughly 4 million bbl/day of "light tight oil" production (LTO) added from US shale deposits since 2008 has certainly depressed oil prices. It's hard to tell by exactly how much, because the growth of shale coincided with high geopolitical risk in oil markets and a volatile global economy. Superficially, it resembles the supply surge of the 1980s. LTO is also generally understood to be high-cost production. Estimates of full-cycle costs vary widely, from the $60s to $90s per barrel.
These factors support the narrative that OPEC, and the Saudis in particular, might be trying to "sweat" shale producers. It's even bolstered by forecasts from the US Energy Information Administration, predating the price drop, suggesting LTO production could plateau within a couple of years and decline not long thereafter.
I see two problems with this scenario. First, shale producers have various options for reducing costs, including some that a more receptive Congress might be inclined to facilitate next year. Then there's the recent history of shale gas pricing. I recall industry conferences in the late 2000s in which speaker after speaker presented curves indicating that the true cost of many US shale gas plays was likely over $6 per million BTUs, and certainly above $5. If that had been accurate, shale gas output should have started to shrink shortly after the spot price of natural gas fell below $4 in 2011. Instead, it has grown by around 13%. This suggests that estimates from outside the shale sector have generally exaggerated production costs that at least one analyst suggests might be as low as $25/bbl on a short-term basis.
If you take a long view, as Saudi Arabia and other Persian Gulf producers arguably must, it's questionable whether the bigger threat to OPEC comes from shale wells that cost a few million dollars each and decline rapidly, or from large-scale projects that can produce for 30 years. An example of the latter is Chevron's new Jack/St. Malo platform, which just began production in the deepwater Gulf of Mexico. (Disclosure: My portfolio includes Chevron stock.) This $7.5 billion facility is expected to recover at least 500 million barrels over its long lifetime. Sub-$70 oil surely means fewer such developments will proceed in the next few years, including offshore opportunities arising from Mexico's sweeping oil reforms. That will have implications for production stretching decades into the future.
The impact of low oil prices could be even more significant for conventional non-OPEC oil production in more mature regions. Oil investments are expected to fall by 14% next year in Norway, threatening that country's energy-focused economy. Prospects in the UK North Sea look no better, with a leading expert warning of long-term damage to the regional oil industry. An announced 2% cut in tax rates on extraction profits hardly seems adequate to offset a 38% price decline since June. As things stand now, voters in Scotland dodged a bullet when they rejected independence, the economics of which depended in part on a sustained recovery in North Sea oil revenues.
Whether shale producers or large investment projects are squeezed more by OPEC's decision to stand pat, it could take months or perhaps years for lower production to appear. As Michael Levi of the Council on Foreign Relations noted, we shouldn't discount OPEC's willingness to act on the basis of its initial reaction to a crisis. However, history also suggests that even if OPEC ultimately acts decisively to defend its desired price level, the outcome may diverge significantly from what they intend. Energy consumers have more choices every day, and that could be the biggest constraint on OPEC's market power going forward.
A different version of this posting was previously published on the website of Pacific Energy Development Corporation.