Illies Sahar and Paul Hickin dwelt on how certain producers of oil agreed to withhold part of their production for the purpose of a desperately sought after increase in the oil price. And they intend to do more of the same in case of not meeting that objective. OPEC will cut output further if oil prices fail to recover: Algerian energy minister. But is OPEC still relevant today ?

A question posed by Ali Ahmad‘s on December 9th, 2018 in This text that is the English translation of a piece he wrote for BBC Arabic.

How relevant is OPEC today?

Although Qatar’s exit from OPEC does not affect much OPEC’s oil production power since the Emirate contributes only 2 percent to the cartel’s production capacity, it does pose serious questions on the future of the organization and the role it is expected to play in global oil markets.

Qatar’s decision to pull out of OPEC may well be driven by political considerations; however, it also reflects the growing signs of discontent among OPEC’s members with how the organization is governed and how its production policies do not necessarily align with those of some member states.

Structural shifts of oil markets and the existence of major imbalances of the needs and policies of OPEC’s members pose a serious challenge to the organization’s unity and its ability to continue to abide by its mandate to “coordinate and unify the petroleum policies of its member countries”. OPEC, as an organization, is likely to continue to exist, but its role has already been weakened and will continue to dissipate as differences among its members become more pronounced and other producers like Russia and the United States increase their market share.

What is OPEC and how it is governed?

OPEC, which stands for Organization of the Petroleum Exporting Countries, can be understood as a club of some of the oil producing countries that is primarily mandated with protecting the interests of its member states and ensuring “a steady income to producers”. At the time of its inception in 1960, OPEC was seen as a “revolt” against private oil companies that seemed to ignore the interests of the producing states.

With Qatar’s exit, the organization currently lists 14 members including Saudi Arabia, Iran, Iraq and Venezuela, who are also founding members of OPEC. In 2017, OPEC members produced around 42 percent of the total global oil supply — more than 39 million barrel per day — with Saudi Arabia, alone, contributing about a third of OPEC’s production. In terms reserves numbers, OPEC members host 70 percent of global proven oil reserves.

On paper, OPEC’s governance and decision making requires the agreement of all member states; however, Saudi Arabia is the de facto leader of OPEC due to its market share and spare capacity that could be utilized to implement OPEC’s policies. Effectively, Saudi’s ability to substantially vary its production and thus directly impacting oil markets made it a price setter.

OPEC’s destabilizing factors

Infighting and cheating: Despite being oil producing countries, OPEC members have different political, social and economic realities. These differences translate into different needs at different times and consequently, and naturally, creates tension and discontent within the group. These different needs are manifested by the “budget break-even” price of oil that each member states requires to fully cover its budgetary expenses (see chart below).

Source: Bloomberg

The numbers shown in the chart above are largely dependent on the production in each country. For example, Venezuela’s very high break-even price is due to its diminished production share of just 4 percent of OPEC’s basket — 500,000 barrel per day below its OPEC output target. Libya is also in similar situation where it is looking to increase production to meet its budgetary needs.

Because of these imbalances, OPEC members continue to cheat to maximize their gains. Cheating is particularly rewarding when production cuts are made and prices are elevated as countries with low compliance eat into the market share of other oil producers. Iran, Iraq, Libya and Nigeria have all attempted to cheat their way to produce more than they are supposed to do.

Cheating has been reported in the academic literature as the one of the main reasons that lead to cartels’ eventual collapse.

Shale oil: It was in 2014 when, driven by Saudi Arabia’s interest in putting pressure on US shale companies, oil supply exceeded demand, despite resistance of other OPEC members with lower tolerance thresholds. The resulting glut sank oil prices below $30 per barrel. Although many US shale companied filed for bankruptcy, the industry emerged much stronger after the crisis due to better adaptation to lower prices, cost cutting measures, and technological efficiencies.

What makes shale oil a destabilizing factor for OPEC is its relatively quick response to oil prices, limiting OPEC’s ability to manipulate prices. The many independent shale companies in the US can gradually increase their supply in response to higher prices, which would eventually exert a downward pressure on prices.

Additionally, advancement in shale technologies and reduced costs of offshore exploration and production allowed new counties to become oil and gas producers, reducing their reliance on imported fuels.

Is OPEC still relevant?

Yes, but its power is diminishing. OPEC remains a dominant player in the global oil markets with production flexibility to smoothen price volatility. Additionally, OPEC members still have a major cost of production advantage compared to non-OPEC and shale rigs in the United States. However, market shifts such as increased share of unconventional oil and gas, especially in big oil consuming countries, and the increasing use of natural gas in power production are increasingly limiting OPEC’s ability to manipulate oil prices as it used to do. Now, shale producers are carefully watching prices and stand ready to react accordingly.

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