OPEC versus the World?

In its last meeting in November 2014 in Vienna, the Organisation of the Petroleum Exporting Countries (OPEC) led by its most influential and dominant member Saudi Arabia refused to put a floor on falling oil prices, keeping production steady at 30 million barrels per day (bpd)[i] opting instead to retain market share in the face of increasing competition and put pressure on high cost producers, USA (particularly the shale oil producers) and Russia.

“We will produce 30 million barrels a day for the next 6 months, and we will watch to see how the market behaves,” OPEC Secretary-General Abdalla El-Badri said after the meeting.[ii] The decision was met with dissent by some members like Iran, Venezuela and Nigeria, whose economies are heavily reliant on revenues from oil exports to balance their budgets and who had been lobbying intensively for production cuts.

Source: US. Energy Information Administration

Supply Glut

After three years of relatively stable prices (average $110/barrel), Brent Crude - the international benchmark for oil prices - plummeted from $111.80/barrel in June 2014 to $47.76/barrel in January 2015. The primary reason was a mismatch between the supply and demand forces, and a belated acknowledgement by the market of global supply outstripping demand. High prices coupled with increasing demand from the most voracious energy consumer China in the last few years led energy companies to aggressively drill oil using unconventional techniques which were unprofitable earlier, increasing US output to the highest level in 3 decades. The US crude oil output has increased from 5 million bpd in 2008 to 9.2 million bpd 2014 and is poised to usurp Saudi Arabia as the world’s largest producer. Fracking and horizontal drilling, which uses sand, chemicals and water to extract oil from shale rock formations, has created an oil boom in US, especially in states of Texas, North Dakota and Pennsylvania. The shale oil boom and weakening global demand due to the slowdown in China, amidst growing geopolitical tensions in the Middle East and speculative impulses (market expectations) contributed to the free fall in price.

Swing Producer

With its decision, The House of Saud seems to have abdicated its traditional role of a “swing producer”- increasing or decreasing production in order to influence prices. Saudi Arabia’s insistence on not cutting output in a bid to not relinquish market share has parallels with the oil price decline of mid 1980’s when in order to preserve high prices, it cut its output but others in OPEC didn’t follow suit and its production fell substantially.[iii] Cooperation and cohesion within the cartel was lax as countries did not adhere to the agreed cuts.[iv] In the current scenario, the Kingdom is playing a waiting game since it has one of the lowest costs of production of crude oil among the Gulf countries and can weather this period of low prices since it has built up huge financial reserves of around $700 billion. Riyadh’s stance has been that markets will self correct and that the decline is only temporary. While the Saudi strategy has been motivated more by an economic assessment of market, low oil prices do offer unique geopolitical advantages over its rivals Iran, Russia and US.

Geopolitical Implications

Iran has repeatedly accused[v] its regional adversary Saudi Arabia of having a tacit understanding with the West for the slump in oil prices in order to put pressure on the Islamic Repubic’s economy and to counter its growing influence in the region.[vi] Western sanctions against its oil exports have reduced Iran’s exports from 2.5 million bpd to 1.4 million bpd. The removal of sanctions, if a final agreement is reached, will add approximately one million bpd to Iran’s production and add to the overall glut.  US Energy Information Administration (EIA) has estimated that extra supply from Iran could sink oil prices by as much as $15.

Saudi Arabia’s decision to maintain the output ceiling was primarily targeted to put the shale oil producers in US out of business. Fracking (or hydraulic fracturing) requires a certain price of around $55-$70 to be economical though recent improvements in production techniques have lowered that threshold. While the price drop has adversely affected the oil producers in regions such as North Sea and Bakken and the dramatic fall in rig count[vii] as a result, it has not derailed the oil boom. The fall in prices has made the industry look for efficient methods and innovate, opposing the conventional wisdom that the shale revolution will go away in the face of low prices.

Low oil prices have already hit revenues of Russia, which currently produces 10.5 million bpd and is one of the major non-OPEC players in the oil market. Its economy is excessively dependent on high oil prices as revenues from oil exports support populist government spending programs that sustain massive public support for President Vladimir Putin. Moody's, Standard & Poor have downgraded Russia’s credit rating to junk status. Already suffering from debilitating western sanctions because of its annexation of Crimea, the country is facing a severe crisis as the ruble was devalued not long ago and inflation is up into double figures.

June Meeting – ‘Business as Usual’

The prices have regained[viii] some of the fall in the months leading up to next week’s (June 5) meeting of OPEC in Vienna. However, there is widespread consensus[ix] that the cartel - which produces 40% of world’s crude oil - will maintain its strategy of “status quo”[x]. More importantly, the rhetoric within OPEC has moderated as Riyadh’s strategy has been vindicated with the prices rising and global demand exhibiting signs of revival.

Where oil prices are likely headed may depend upon more than just plain demand and supply. The war in Yemen, the advance of Islamic State (IS) to southern parts of Iraq where majority of the country’s oil production and export facilities are, escalation of Russian aggression in Ukraine, the impact of removal of Western sanctions on Iran, resilience of shale producers in the US are all going to have an impact. The prices may be influenced by the geopolitical situation as well as market speculation as it responds to those variations. The prediction of oil prices or forecasting is an inexact science.[xi] However, it is unlikely that the oil prices are going to touch the $100/barrel mark soon.

Earlier last month, Saudi Arabian oil minister Ali Al-Naimi in an interview said ‘No one can set the price of oil - it’s up to Allah.’ Perhaps some divine intervention may make the recovery quicker. [xii]

The author is Research Assistant at CLAWS. Views expressed are personal