OPEC’s Trillion-Dollar Miscalculation
Forbes, 8 January 2016
I suspect if Saudi Arabia were able to travel back in time to OPEC’s November 2014 meeting, the oil markets would look very different today. Because at that meeting the group made a decision that has thus far proven to be very costly to OPEC members.
The decision left me scratching my head at the time. Whenever I try to anticipate an OPEC decision, I first ask myself, “What would I do if I were responsible for making that decision?” Of course to OPEC, the self-interests of its members are more important than the interests of the rest of the world. Further, OPEC typically does what Saudi Arabia wants, so OPEC’s interest is really Saudi Arabia’s interest, or at least what the Saudis think is best for the long-term good of the group.
But I think the group made a monumental miscalculation at that 2014 meeting by embarking on an entirely unnecessary strategy. Historically the group — and more specifically Saudi Arabia, which is responsible for over 30% of the group’s oil production — has functioned as the world’s swing producer for crude oil. If the world needed more oil production, OPEC could bring more barrels online. If the world needed less, some could be idled. A stable price, the group asserted, was the key to matching global supply and demand.
That strategy was essentially abandoned at the November 2014 meeting when OPEC announced they would defend market share that was being lost due to the rise of non-OPEC production, especially from the United States. Some have argued that OPEC had no choice but to defend market share instead of cutting production to balance the market, but I disagree. Consider the following.
In 1994 OPEC produced 39.9% of the world’s oil. In 2004, OPEC’s share had risen to 42.1% — just before oil prices would go on a run that would take them above $100/bbl. The rise of shale oil production in the U.S. added 4.9 million barrels per day (bpd) of oil to the market between 2008 and 2014, and OPEC’s share of global oil production fell slightly to 41.2% in 2014. (Note that while there was a ban on exports of U.S. oil, the rise of shale oil backed out imports and put that oil on the open market, and exports of finished products from U.S. oil rose sharply over that time period). While OPEC’s 2014 market share was well below the ~50% market share OPEC held prior to the 1973 oil embargo that rocked global economies, it should be clear that with more than 40% of global production, OPEC maintains a position of dominance over the global crude supply.
Overall, OPEC members produced 36.5 million bpd of oil and natural gas liquids in 2014. When they met in November 2014, oil prices had already suffered a sharp fall from summer, but crude was still trading at ~$75/bbl. The world was probably oversupplied at that time by 1-2 million bpd, so if OPEC had merely decided to remove 2 million bpd off the world markets — only 5.5% of the group’s combined 2014 production — the price drop could have easily been arrested and maintained in the $75-$85/bbl range. That would have still given them 38.9% of the global crude oil market. For that matter, a production quota cut of 13% could have removed from the market a volume equivalent to all of the U.S. shale oil production added between 2008 and 2014.
Would that strategy have cost them market share? Sure, a small amount. But assume they then pumped 34.5 million bpd at $80/bbl. That’s just over a trillion dollars in annual revenue. If instead they pump 36.5 million bpd at $35/bbl — which is actually more than they are getting as I write this — that’s $466 billion in annual revenues. The annual difference in those scenarios is $541 billion. OPEC already lost out on that much in 2015 from the sharp drop in prices. If prices remain at these levels for most of this year, the foregone revenue for OPEC in 2015 and 2016 will easily top $1 trillion since that November 2014 meeting.
Was this a miscalculation on the Saudis’ part, or is there a deeper strategy at play? I firmly believe they failed to anticipate how sharply oil prices would drop. I think they believed that oil prices could fall somewhat below $75/bbl for a short period of time, and that would be enough to bankrupt a lot of the shale oil companies and allow OPEC to recapture market share. Instead, the shale oil producers slashed costs, and while some producers have gone bankrupt — and other bankruptcies are undoubtedly on the way — shale oil production has proven to be much more resilient than the Saudis and OPEC expected.
At that time, the Saudis argued that it didn’t make sense for them to cut production. The highest-cost producers, they argued, should be the ones to cut. It is true that defending oil prices by cutting production — the strategy favored by Iran, Nigeria, and Venezuela — would have propped up these high-cost producers. But the shale oil boom was going to run its course and probably peak in a few years. OPEC still controls 1.2 trillion barrels of proved oil reserves — 72% of the world’s total. Thus, unless they expected shale oil production to continue to expand by millions of barrels per day every year, the group could have tightened up production as needed to maintain much higher margins on a shrinking market share. They would have higher revenues today, knowing they would capture back market share as the world’s non-OPEC reserves depleted.
Their strategy may yet pay off though. If they can keep enough marginal production sidelined over time, this period of financial difficulty could enable them to recapture higher margins in the future. If they are able to realize $10/bbl more for their remaining reserves as a result of the current strategy, then their pain will be worth it (for them) in the long run.
Meanwhile, I don’t expect the average consumer to shed a tear for OPEC. In fact, I will discuss the many beneficiaries of OPEC’s mistake in my next article.