Posted on by John Sloman

OPEC’s juggling act

OPEC, for some time, was struggling to control oil prices. Faced with competition from the fracking of shale oil in the USA, from oil sands in Canada and from deep water and conventional production by non-OPEC producers, its market power had diminished. OPEC now accounts for only around 40% of world oil production. How could a ‘cartel’ operate under such conditions?

One solution was attempted in 2014 and 2015. Faced with plunging oil prices which resulted largely from the huge increase in the supply of shale oil, OPEC refused to cut its output and even increased it slightly. The aim was to keep prices low and to drive down investment in alternative sources, especially in shale oil wells, many of which would not be profitable in the long term at such prices.

In late 2016, OPEC changed tack. It introduced its first cut in production since 2008. In September it introduced a new quota for its members that would cut OPEC production by 1.2 million barrels per day. At the time, Brent crude oil price was around $46 per barrel.

In December 2016, it also negotiated an agreement with non-OPEC producers, and most significantly Russia, that they would also cut production, giving a total cut of 1.8 million barrels per day. This amounted to around 2% of global production. In March 2017, it was agreed to extend the cuts for the rest of the year and in November 2017 it was agreed to extend them until the end of 2018.

With stronger global economic growth in 2017 and into 2018 resulting in a growth in demand for oil, and with OPEC and Russia cutting back production, oil prices rose rapidly again (see chart: click here for a PowerPoint). By January 2018, the Brent crude price had risen to around $70 per barrel.

Low oil prices had had the effect of cutting investment in shale oil wells and other sources and reducing production from those existing ones which were now unprofitable. The question being asked today is to what extent oil production from the USA, Canada, the North Sea, etc. will increase now that oil is trading at around $70 per barrel – a price, if sustained, that would make investment in many shale and other sources profitable again, especially as costs of extracting shale oil is falling as fracking technology improves. US production since mid-2016 has already risen by 16% to nearly 10 million barrels per day. Costs are also falling for oil sand and deep water extraction.

In late January 2018, Saudi Arabia claimed that co-operation between oil producers to limit production would continue beyond 2018. Shale oil producers in the USA are likely to be cheered by this news – unless, that is, Saudi Arabia and the other OPEC and non-OPEC countries party to the agreement change their minds.

Videos

OPEC’s Control of the Oil Market Is Running on Fumes Bloomberg (21/12/17)
Oil Reaches $70 a Barrel for First Time in Three Years Bloomberg, Stuart Wallace (11/1/18)
Banks Increasingly Think OPEC Will End Supply Cuts as Oil Hits $70 Bloomberg, Grant Smith (15/1/18)

Articles

Oil prices rise to hit four-year high of $70 a barrel BBC News (11/1/18)
Overshooting? Oil hits highest level in almost three years, with Brent nearing $70 Financial Times, Anjli Raval (10/1/18)
Can The Oil Price Rally Continue? OilPrice, Nick Cunningham (14/1/18)
Will This Cause An Oil Price Reversal? OilPrice, Olgu Okumus (22/1/18)
The world is not awash in oil yet
 Arab News, Wael Mahdi (14/1/15)
‘Explosive’ U.S. oil output growth seen outpacing Saudis, Russia CBC News (19/1/18)
Oil’s Big Two seeking smooth exit from cuts The Business Times (23/1/18)
Saudi comments push oil prices higher BusinessDay, Henning Gloystein (22/1/18)

Report

Short-term Energy Outlook U.S. Energy Information Administration (EIA) (9/1/18)

Questions

  1. Using supply and demand diagrams, illustrate what has happened to oil prices and production over the past five years. What assumptions have you made about the price elasticity of supply and demand in your analysis?
  2. If the oil price is above the level at which it is profitable to invest in new shale oil wells, would it be in the long-term interests of shale oil companies to make such investments?
  3. Is the structure of the oil industry likely to result in long-term cycles in oil prices? Explain why or why not.
  4. Investigate the level of output from, and investment in, shale oil wells over the past three years. Explain what has happened.
  5. Would it be in the interests of US producers to make an agreement with OPEC on production quotas? What would prevent them from doing so?
  6. What is likely to happen to oil prices over the coming 12 months? What assumptions have you made and how have they affected your answer?
  7. If the short-term marginal costs of operating shale oil wells is relatively low (say, below $35 per barrel) but the long-term marginal cost (taking into account the costs of investing in new wells) is relatively high (say, over $65 per barrel) and if the life of a well is, say, 5 years, how is this likely to affect the pattern of prices and output over a ten-year period? What assumptions have you made and how do they affect your answer?
  8. If oil production from countries not party to the agreement between OPEC and non-OPEC members increases rapidly and if, as a result, oil prices start to fall again, what would it be in OPEC’s best interests to do?