Sunday, 5 March 2017

OPEC and oil: Out of ammo?

There is little more OPEC could do to increase its revenue.

The OPEC agreement to cut production has shifted oil prices to a higher level, around $55 now compared to $45 prior to the deal. But there are signs that higher oil prices are leading to a revival in US shale production. Most energy market forecasters expect increased US production in 2017 after a decline in 2016. Could OPEC do anything to fend off the re-emergence of US shale? The short answer is probably no. If OPEC decides to cut its production further, this will lead to a loss in market share without any significant gain in prices. Conversely, the benefits from flooding the market to increase OPEC’s market share are only marginal and uncertain. 

1. Further production cuts by OPEC would be counterproductive. Further cuts would only lead to temporary improvement in prices, as more and more shale companies would become profitable leading to higher US production and a return of prices to pre-cut levels. This means that OPEC would end up with lower oil revenues as it loses market share without any gains in prices.

2. Despite increasing its production aggressively in 2014-16, OPEC allowed shale an escape route. OPEC’s actions reduced spot prices (the price at which oil is traded for immediate delivery), but it did not reduce futures prices (the price at which oil is traded for delivery in the future) below shale’s cost of production. The chart below shows that a shale company with production cost of $50 per barrel was still able to make profits in 2o15 by selling its output for delivery in 12 months’ time at the price of $55 in January 2015 and $51 in October 2015. Selling oil using futures contracts allowed many shale firms to survive during the oil slump.

3. If OPEC floods the market to reduce the spot as well futures prices of oil below the cost of US shale, then the gains would be small. Although the gain in market share could more than compensate OPEC for lower prices, the benefits are likely to be marginal. Even if we assume that the new more aggressive market share strategy would be twice as painful for shale as the one pursued in 2014-16, the overall increase in OPEC’s revenues would be small, estimated to be around $12bn per year or less than 0.5% of the cartel’s GDP. Furthermore, these gains would be quite uncertain given the uncertainty about the reaction of shale and how their production costs would evolve over time.

To summarise, OPEC’s November cuts were successful because there was room for prices to rise before hitting the cost of production of US shale, estimated to be around $50-55. Now that prices are at that level, further cuts have little more to achieve. Flooding the market on the other hand might seem more sensible, but back of the envelope calculations suggest the benefits to OPEC are small and highly uncertain.

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