06 04 2020

The oil price: when cartels fall apart

Moisture flare at the Obenour 1 and 2 well on the Evanson family farm in McKenzie County Moisture flare at the Obenour 1 and 2 well on the Evanson family farm in McKenzie County By Tim Evanson - https://www.flickr.com/photos/23165290@N00/9287130523/, CC BY-SA 2.0, https://commons.wikimedia.org/w/index.php?curid=27600010

The recent drop in oil prices is generally referred to as a ‘Saudi-Russian price war’. This is a wrong description. Two things are happening. Firstly, as renewables are becoming cheaper and cheaper, oil is becoming increasingly irrelevant, and all countries with large oil deposits are scrambling to get as much as possible out of the ground before it is too late. Secondly, the OPEC+ oil cartel has failed, as outsiders – often called ‘free riders’ – have increased production so much that the cartel is no longer worth while. These two factors are the death knell for OPEC+ and high price oil – the good times for the oil industry will never come back. The fall in demand because of COVID-19 is not the cause, it is only the trigger.

I have discussed elsewhere the increasing lack of competivity of fossil fuels, as the cost of renewable energy continues falling. Add to this the political pressure in many countries to phase out fossil fuels to combat climate changeTrump not withstanding. This is to my opinion the most fundamental long-term factor behind the recent collapse in oil prices. Of course short-term factors are important as well: the drop in demand due to COVID-19 and the lack of spare capacity for storage. But that is a transitory phenomenon.

The other fundamental factor is the collapse of the OPEC+ cartel. This has as mentioned been referred to as the Saudi-Russian price-war, or alternatively as a Saudi-Russian frontal assault to undermine the thriving US shale oil industry. But that is not what is happening.

As any undergraduate economics student will know, cartels are based on monopoly pricing. The fixing of the price is a balancing act between squeezing as much money as possible out of the customers and at the same time avoid provoking a too high contraction of demand. That is called the optimum monopoly price. That works fine as long as the cartel members are not cheating too much on the agreed production quotas. And as long as the monopoly is not seriously contested by producers that are not part of the cartel.

In the past, cheating by the cartel members used to be the main problem for OPEC. But outsiders free-riding on the high cartel price has become an increasing problem as well. Russia has been one of the outsiders benefiting from the high oil prices during the last decade, but in 2018, after pressure from Saudi Arabia, it (reluctantly) accepted, together with a group of other non-OPEC producers, to join a looser version of the cartel, often referred to as OPEC+. That helped pushing the oil price up for some time.

Another outsider, the US, has during the last couple of years been the main beneficiary of the OPEC+ agreement, as the high price has permitted high-cost shale oil producers to increase their production and the US has now become the world’s biggest oil producer, while the OPEC+ members have restricted their production as can be seen in the below chart.

Source: BP Statistical Review of World Energy 2019

This has obviously caused malaise within OPEC+, and in particular the Russians have been discontented with having to give away market share to US shale oil. They ask why low-cost producers should restrict their production to make way for US high-cost shale oil producers. Then came the fall in demand for oil because of COVID-19, Saudi Arabia suggested to Russia a further cut to production, Russia refused to continue the game and the oil price dropped as a stone.

Oil is a finite resource, and the cost of extracting it depends on local conditions. We don’t know exactly how much it costs, as it is a very secretive industry, so all estimates include an element of guessing. It is generally believed that Saudi Arabia (and other Middle East producers) have a privileged position: the oil sprouts out of the ground with little effort and extraction costs are estimated to be 8-10 USD per barrel (or even lower). Russia is thought to be able to produce at around 10-12 USD per barrel. We also know the other extremes: Canadian tar sands, oil in Arctic deep waters and other difficult oil deposits. Generally, we would expect the cheapest sources to be exploited first, and the most expensive latest – if at all. But when a cartel keeps up high prices, high-cost outsiders have an opportunity to expand their production and turn a profit.

The cost of production of US shale oil is everybody’s guess. Some years ago it was thought to be on average around 60 USD per barrel or higher, but after the crisis in 2015 the shale oil producers have cut costs and it is argued that it is now in the 40-45 USD range, which means that as long as the oil price is around 40-45 USD or higher, they will stay in business. A recent report by an IMF reasearch unit claims that the cost of US shale oil is only around 20 USD per barrel, while the production costs in Russia are claimed to be around 40 USD. That is unlikely – if it were the case, then the US should be happy with the falling price as it would squeeze out the Russians. But they are no happy at all.

The US shale oil industry is a bit of a mystery. During the last decade there have been many predictions that the collapse of the industry was imminent, but it is still around and growing rapidly – at least up to now. Even so, shale oil companies have failed to produce a positive cash flow for the last decade. That makes it look like a big Ponzi Scheme – they borrow at high cost (near-junk bonds) to be able to continue drilling and pay back loans they have already taken. Now they suddenly can’t borrow any more and many of them therefore face default. They are clinging to the hope that OPEC will come to their rescue by pushing up the oil price again, perhaps with a helping hand from their oil-happy President Trump.

Take a look at the development of the oil price during the last decade:

Source: BP Statistical Review of World Energy 2019

The US shale industry went into crisis in 2015 when the oil price fell below 40 USD per barrel. Then OPEC+ intervened to limit production and prices went up again to 60 USD. The US shale industry was shaken, but after reducing costs it staged a come-back as 60 USD apparently was enough for it to prosper – despite the failure to produce a positive cash flow.

What is now the optimal strategy for OPEC+? For the low-cost OPEC producers the long-term aim must be to extract as much of their oil as possible within the next decade or two, before the competition from renewable energy, electric cars and all that starts hurting seriously. Let us guess that the US shale companies actually are able to produce oil at a cost of 35-45 USD, at least the most efficient of them working on the most productive oil fields. The optimal strategy for OPEC+ would then be to produce enough oil to keep the price in the 35-40 USD range. That will probably squeeze at least part of the US shale industry out, and still leave most of the OPEC+ countries a handsome profit. That is probably also what Russia had in mind when it – as demand started falling because of COVID-19 - suggested to Saudi Arabia to wait and see, rather than to cut back production. The Saudi strategy – if they really have one – seems to be to flood the market with oil to quickly bankrupt the US shale oil producers (and if possible the Russians too). But there is a risk that the House of Saud with its army of princes living off the oil revenue will be bankrupted itself in the process. It is estimated that Saudi Arabia with an oil price of 35 USD will run a public sector deficit corresponding to 15% of its GDP IN 2020. That is not tenable. In a cartel war it is not enough to have low production costs – deep pockets are also necessary.

My guess is that Russia and Saudi Arabia and the rest of OPEC+ will agree to make at least a transitory cut in production, but to keep the Russians within the agreement in the longer run, they will have to aim at a price level that will only permit the most efficient US shale-oil producers to prosper. That is in the 35-45 USD range. The US will not be happy with that as it dooms an important part of its shale-oil industry.

What can the US do? How can this sinister international plot to sink the prospering US oil-industry be confronted? The US Government is pressing its Saudi underlings hard to cut production, even threatening with withdrawing the support to the House of Saud. Trump has reportedly told King Salman that “you might not be there for two weeks”. The Russians are more difficult to deal with, and threats of more sanctions are not likely to make them cut production. Even if the US Government succeeds in getting OPEC+ to make transitory cuts in their production during the COVID-19 pandemic, this it not a viable long term strategy. In the short run it can furthermore avert a sudden collapse of the shale oil industry by bailing out some of the weakest companies, or by arranging for a take-over by some of the bigger companies (e.g. Exxon, Chevron, Shell and BP). Part of the oil industry is lobbying for a tariff on imported oil. “Plan A is getting Saudi Arabia and Russia to talk and cut. But if that takes too long or fails, the president will resort to plan B — protectionist measures to assist domestic producers,” says Bob McNally, head of consultancy Rapidan Energy Group. That is an interesting proposal – there would then be two markets for oil, the US home market with high prices and a world market with lower prices. Or many closed home markets with high prices and a low price international market where surplus production is dumped – like the market for e.g. sugar has been working for decades. Another proposal is to force US shale-oil producers to cut production, e.g. as part of a US-OPEC+ deal. I guess this would face problems with US competition laws, but it could perhaps be done as a transitory measure arguing national security.

The US Government is not in an enviable position right now. The normal remedy would be to use the US military supremacy to invade a country claimed to be the evil culprit, but apart from boosting the President’s popularity in the short run, it is difficult to see how that will contribute to saving the US shale industry in the longer run – only lower production costs can (coupled with lax environmental laws, as shale is a very dirty industry).

Cheap oil has come to stay. The cost of production of US shale and similar high-cost producers will in the future set the upper limit for the oil price in the longer run, and all producers that are able to turn a profit at that price will scramble to get their oil out of the ground before it is too late.

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Thorbjorn Waagstein

Thorbjørn Waagstein, Economist, PhD, since 1999 working as international Development Consultant in Latin America, Africa and Asia.

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