December 22, 2016    5 minute read

Is The OPEC Deal Just A Return To Normal?

The New Reality    December 22, 2016    5 minute read

Is The OPEC Deal Just A Return To Normal?

The announcement on December 10th that a consortium of non-OPEC countries, led by Russia, would follow OPEC in cutting oil production for at least the next sixth months has led to a further climb in the price of oil futures. WTI futures jumped by 6% in the days after it was announced that the meeting would take place, which came in the wake of the OPEC announcement on November 30th, which caused a 10% surge in prices.

Oil prices have been on a steady downward course since Saudi Arabia abandoned a price-target strategy in November 2014, opting instead to seek a greater market share by increasing production. The surge in global oil supply pushed prices down significantly; as Saudi Arabian output surged, prices fell from over $100/barrel to a low of just over $29/barrel in February.

Many believe the move was intended to curtail production from the booming US shale industry, which had been able to bring online many higher cost wells, threatening OPEC’s control of the market. Indeed, the move had the desired effect, as US shale oil production fell by 587,000 barrels/day between peak production in March 2015 and November 2016. According to Reuters, more than 50 oil and gas companies have gone bankrupt since early 2015.

A Pyrrhic Victory?

However, the damage caused by this change in strategy was not just confined to the United States. The economies of many OPEC members are heavily reliant on oil production and exports, and the decline in price has led to increasing government deficits in several member states. Both Saudi Arabia and Iraq have seen their deficits rise to nearly 20% of GDP, with other Gulf States experiencing deficits of more than 10%. Despite the announcement in April of an ambitious plan to restructure the Saudi economy and reduce dependence on oil, the country remains dependent on oil for 90% of government revenue, and in a country with more than two thirds of its citizens working in the public sector, such dependence can surely not be healthy in the long term.

The deal represents a significant boost to OPEC’s attempts to combat the excess supply that has significantly depressed oil prices. Though OPEC controls about 41% of global production of crude oil, it notably contains only one of the top five producers (which are the US, Saudi Arabia, Russia, China and Canada) based on 2015 output. The addition of Russia and other non-OPEC members to the production cuts brings the share of the market up to 59%, and therefore bolsters the likelihood of a return to the higher prices of days past.

How High Can They Go?

Before Saudi Arabia opted to change its production level, the price of oil had been hovering around $100/barrel for several years. Therefore, one might be inclined to imagine that prices would gradually drift upwards as production cuts take place, and settle at their previous level. Motorists in the UK would once again face prices above 130p/l and grumble about taxation being excessive (interestingly enough, OPEC is keen to point out on their website that the UK government takes 67.2% of the revenue from each litre of fuel at the pump, whilst the OPEC member takes just 19.9%).

67.2% of the revenues for a litre of fuel goes to the UK government

However, the long period of high prices led to significant developments in the extraction of unconventional oil – oil extracted through methods other than a traditional well, such as tight oil fracking and oil sands.

Though these types of projects initially faced very high extraction costs per barrel, their spread and subsequent research have lead to significant reductions in costs. Gone are the days where fracking was viable only at $90/barrel.

Many experts now believe that fracking wells are more competitive than deepwater wells, such as those in the North Sea. Wood Mackenzie estimate that by 2025, Eagle Ford could be producing five million barrels/day at a break-even price of around $48/barrel, and the enormous Bakken play could be producing more than ten million barrels/day at below $60/barrel break-even.

Fracking wells also have significantly lower fixed costs than deep sea wells, meaning that they can be easily shut down or restarted depending on profitability, whereas traditional wells tend to simply keep running irrespective of fluctuations in price.

Conclusion

So, where will oil finish up settling? It is hard to imagine oil rising above $60/barrel anytime soon, especially given the enormous potential supplies of shale oil in the US. For now, the majority of reserves are either untapped or have extraction costs above the $60 mark. In the long term, these costs will fall, and the US will further emerge as a threat to OPEC’s control over the oil market.

Given this great potential, it is not unthinkable to imagine that the US might one day become a net exporter of oil. Even if this does not end up being the case, as domestic production rises, dependence on foreign exports will naturally decline. This may have some major geopolitical implications, as close Saudi-US relations are largely due to the Kingdom’s oil. Perhaps this is why some have suggested that there was more than just economic motive behind Russia’s support for OPEC.

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