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OPEC Price Band

Not very long ago, oil prices traded at well below $20/b and OPEC anxiously came up with a mechanism which it termed as “OPEC Price Band' $22-$28/b”. The rationale for this price band, was that OPEC members would find it sufficient for the growth of their oil and gas industry while the price was high enough to meet their government budgetary requirements. However, only a few years after this mechanism was introduced, oil prices exploded upwards and OPEC was forced to abolish its own price band in favor of higher oil prices.

Burgeoning Oil Prices – OPEC Fortune

Oil producers always look for higher oil prices, and why not? It improves profitability, makes more funds available for the development of oil and gas resources and meets the ever-growing budgetary requirements of the governments.

Oil prices rose higher and higher, and in July 2008 peaked at $147/b – good news for oil producers and oil exporters but painful for the oil importing countries and particularly for consumers.

There are many reasons for the rise in oil prices since 2003 - market fundamentals, civil unrest/strikes in some of the major oil producing countries, the flip/flop of inventories, speculators, hurricanes, conflict in Middle East, and higher cost of production. Shortly after these record prices, the world witnessed the abrupt collapse of oil prices to below $40/b in late 2008 and early 2009.

Surprisingly, oil prices then bounced back and remained over $100/b for quite an extended period of time before plunging back below $30/b.

The key developments in oil prices from 2007 to September 2016 are highlighted in the following bullet points:

• 2007-2008 – Over a 20-month period, oil prices (average monthly Brent) moved up from $53.68/b in January 2007 to 113.02/b in August 2008 (July averaged $133.16, though oil prices went as high as $147/b). Only 6 of these 20 months saw oil prices above $100/b, averaging $88.59/b over the period.

• 2008-2009 – Over a 7-month period (Sept 2008-March 2009), oil prices moved down from $98.13/b in September 2008 to $40.35/b in December 2008, averaging $56.58/b.

• 2009-2014 – Over a 64-month period (April 2009-July 2014), oil prices remained above $100/b for 42 months, averaging 97.89/b.

• 2014-2016 – Over this 26-months period (Aug 2014-Sept 2016), oil prices moved down from $106.64/b in July 2014 to $46.69/b in September 2016 (with a low of $30.75 in January 2014), so far averaging $54.33/b. However, since August 2015, average monthly oil prices have remained below $50/b.

 

OPEC’s Successful Policies

In the past, whenever oil prices have slumped OPEC would help them to recover promptly through the sincere and concerted efforts of OPEC members. So, what is different this time? Oil prices have remained well below $50/b or hovering close to $50/b over extended period of time. Why are OPEC members not happy with the oil price tag of $50/b as compared to the old OPEC price band of $22-$28/b? Will OPEC be able to steer oil prices to its desired levels, enabling its members to meet their respective government’s budgetary requirements (ranging from $47 in Kuwait to over $215/b Libya)? If not, then what should be done to keep their economies afloat without heavy reliance on the oil and gas sector?

A Dilemma for OPEC Policies

When oil prices tumbled down after mid 2014, OPEC discovered that the main culprit was the booming U.S. shale oil industry. The cartel had to decide how to deal with this new emerging threat. The decision was between living together in a competitive market or attempting cut the emerging shale industry at the knees by means of sustained low prices.

OPEC decided to take the later approach. Instead of taking cost cutting measures to meet the new challenges from U.S. shale oil and diversifying their oil based economies, they flooded the market. A clear intent was to keep oil prices low and knock out U.S. shale oil producers in order to maintain market share. The perception was that in just a few months, the U.S. shale oil industry would have perished, unable to cope with the lower oil price environment over an extended period of time.

OPEC Policies Back Fire

Contrary to their expectations, U.S. shale oil production did not decline as much as anticipated. In fact, OPEC - hurt by their own action of flooding the market - kept the oil prices lower for longer still. The cartel was seemingly unaware of the speed of technological advancement that continues to bring down breakeven prices for shale. Advances in drilling technology, optimized resource management policies and the smart use of hedging have allowed the U.S. shale oil industry as a whole to stay afloat even as bankruptcies pile up.

The consequences of a prolonged period of softer oil prices has now started to pinch OPEC nations themselves. The plan to defeat shale oil producers backfired. Middle-East stock exchanges, fiscal policies and economic growth became the immediate casualty of this strategy. Efforts were made to reduce fiscal deficits by improving non-oil revenues and other austerity measures including cutting subsidies, but are these measures enough?

What is Different This Time?

With no alternative choice, OPEC went back to its old wisdom of manipulating oil production as it has done so successful in the past. Knowing that this time around, this monster task cannot be accomplished without the support of Russia, so efforts were made to motivate Russia to board the sinking ship. Russia needed to join due to its economy reeling from low oil prices. In the past few months, the news of such freeze/production cuts has had an impact on market sentiments the same way as it had in the past. That is, any news of a production cut or freeze pushed and prodded oil prices upwards. Repeatedly, OPEC’s members failed to agree on a tangible production cut, asking to be exempted for their own political and economic reasons.

Mediocre cash flows have pushed oil producers to up output even further. Both Russian and Saudi Arabian production was up over 11 mmbd, despite weaker global oil demand. Consequently, oil prices remained subdued as the supply glut continued unabated. Oilprice.com’s Andreas de Vries and Salman Ghouri recently published an article on the 5-negative factors for oil prices that highlights why oil continues to sell off.

Challenges for the oil industry in the short/long term

U.S. shale oil remains the biggest threat to the industry and oil prices over the short-medium term. While structural changes in the automotive industry and the rising role of renewables are yet another threat that challenges the survival of oil in the medium to long-term.

U.S. shale is not only reducing break-even cost, but they also learned how to respond to changes in oil prices. A good example of this is the reduction in well completion. DUCs were piling up as oil prices remained under $50. At the end of September 2016, the number of DUCs were up to 5069 from 3698 in December 2013. In contrast, the number of DUCs declined when oil prices went above $50 as the chart below shows.

US shale oil drilling profile

 

How Responsive Is U.S. Shale Oil to Oil Prices

As far as future of U.S. shale oil is concerned, if oil prices are allowed to increase from $50/b to $80/b due to OPEC and Russia’s successful collaboration, the question is how long it takes shale oil to respond?

The Author published a paper “Will OPEC Use This Strategy To Defeat U.S. Shale?” which highlights that if oil prices are allowed to increase from $50/b to $78/b between March 2016 to December 2020 how U.S. shale production would respond to price changes. In the reference case, U.S. shale oil production from the Bakken, Eagle Ford, Niobrara, Permian and Utica responded due to the increase in oil prices, surpassing their respective peaks to date. By December 2020, total U.S. shale oil production from the given seven basins is forecasted to increase to 6.78 mmbd – an increase of 48 percent compared to 4.86 mmbd in September 2016.

US Shale oil forecast March 2016 to Dec 2020.

What Can The Oil Industry Do To Improve Their Odds?

The oil industry should realize sooner or later that the era of $100/b or over is technically over. The underlying threats are real and they should develop alternate strategies for their own survival. Moreover, oil dependent countries should also look for other options to reduce their reliance on oil based revenues, removing subsidies and introduce tax reforms are just two options to avert a major economic downturn.

 

 

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