OPEC’s Terrible Choice:  Its Next Cut Could be a Permanent One.

OPEC seems in control of the oil world, but in fact it is terribly constrained.

A review of OPEC’s previous production cuts reveals that:

–  it cannot sustain a market share strategy
–  it takes the lead in output cuts when demand declines, but it cannot assume non-OPEC will follow
–  it is unable to influence demand, only respond to it

OPEC’s cuts have typically worked when underlying consumption has been strong, and non-OPEC production slow to respond.

But things change; as global demand enters structural decline, and non-OPEC production grows, diversifies and quickens, this leads to a stark conclusion: OPEC’s  latest cut may need to be permanent; a long-term production cap, with all of the consequences for its economies and assets.

An OPEC Retrospective: Mabro and the 1998  Production Cut, “A Market Share Strategy Is not Sensible”

As OPEC continues its quest to rebalance the oil market, it’s worth taking a short overview of previous cuts, and a wider perspective on the oil market. 

In late 1997 the oil industry faced a drop in oil price below $10/bbl as demand fell due to the Asian financial crisis, and OPEC had a choice to make: continue with production levels, and attempt to dominate market share, or make a production cut.

One of OPEC’s main advisors at the time, the late Robert Mabro, who founded the Oxford Institute for Energy Studies, wrote a paper on the key policy lessons from that episode.

It’s worth considering his reflections in detail. His comments on an OPEC  market share strategy are summarised below:

“… the pursuit of market share by an oil exporter or a group of exporters is not a sensible policy because the costs involved can be very high during its implementation and the future benefits too distant and too uncertain.

The critical characteristic of oil prices is that, on average, they are well above production costs. This is precisely why they generate revenues on which governments with few other sources of income rely.

But this is also why price wars cause huge losses and do not achieve their objective, which is to eliminate the competition. To succeed prices have to fall below costs. On their way down they will remove some marginal barrels from the market, but not enough to increase the volumes supplied by the low cost producers by a proportion sufficient to compensate for the loss in price.

Prices have to fall a long way and price expectations have to remain depressed for a long time for a significant improvement of the market share of those who launch an oil price war.

No oil-exporting country has the financial resources which enable it to sustain such a policy.”

Mabro’s conclusion? The OPEC market share policy was a myth – such a strategy could not work even in principle: the risks of increasing “volumes against inelastic demand” would always tend to cause prices to fall more sharply than any volume increase, and OPEC states did not have the economic strength to pursue this.

As he noted:

“For this simple reason those who persistently advocate that OPEC should pursue a market share policy come what may, that is maximise volumes without worrying about the price impact, are not offering sensible advice.”… “uncoordinated production increases may exact a heavy toll in terms of revenues for governments and of cash flows for companies”

The chart below highlights how strong Mabro’s point is: on a per capita basis OPEC’s revenue has tended to plunge during any price crisis caused by excess supply. In 1997-98 it fell by a third: in the latest episode of 2014, by over two-thirds.

Ceding Market Share: The Only Price Control is OPEC Production Cuts

Mabro continued his analysis:
• Saudi Arabia is not a swing producer, able to vary output according to demand: it is a “big fixed-volume producer” which “does not mitigate the impact of excess demand or supply”.  He concluded that Saudi Arabia’s role should be more as the coordinator of policy, typically production cuts.
• Global oil has an institutional mechanism for coordinating decisions – OPEC – yet OPEC  “does not seem capable of preventing price crises, but is only able to respond to them”.

The lesson from 1998 seemed clear. Although a complex world industry, oil really only has one successful coordinating mechanism: OPEC production cuts. (Mabro also suggested how OPEC could manage price spikes, but price ranges and monitoring ideas were never implemented effectively).

Mabro estimated that at the time of the 1998 price crisis, the excess of production over supply was about 1.3 million b/d pa.

But in a series of cuts implemented from 1998 – 2000, OPEC removed a total of over 4.5 million b/d from supply.

The deeper cut was necessary to cover length of implementation, compliance issues, and the need to work off inventory backlogs, before demand could begin to outpace supply again.

As before and since, most of the cut was executed by OPEC; in fact Middle East OPEC. Non-Gulf state OPEC and non-OPEC contributed a small minority, leading to a charge of being “free-riders”. Mabro noted  that some form of formal non-OPEC coordination should be attempted in future, but this has never been possible.

OPEC’s Production Cuts Review: 1996 – 2009, source Bloomberg

By mid 2000 prices recovered to over $30/bbl from under $10/bbl.

Three key factors all played their part:

– OPEC leadership, coordination and communication of production cuts
– Non-OPEC production slowing or curtailed
– Underlying demand recovery

In sum, Mabro’s analysis highlights how OPEC is actually severely constrained, although seemingly dominant.

– It cannot realistically pursue a market share strategy – more recent events of 2014 reinforce this wisdom; when Saudi Arabia maintained production against a 60% drop in prices it had to reverse policy after even marginal cost barrels remained resilient.
– It has to lead production cuts when demand declines, but it cannot assume non-OPEC will follow
– It cannot influence demand, only respond to it – Mabro suggested the OPEC logo be a tea-bag, as “it only works in hot water”.

This tight logic leads to an uncomfortable conclusion for OPEC: if demand enters chronic low-growth or decline, OPEC will not be able to pursue a market share policy, or depend upon non-OPEC to follow any major output cuts.

The only way it will be able to influence price, and avoid revenue shortfalls will be though a long-term, or even permanent production cap.

How likely is this scenario?

The OPEC Production Cap: A Static World with Non-OPEC’s Endless Investment

Mabro also used the 1998 experience to set some principles for the future.

He noted the following:

“prices are of greater importance than volumes in a static world, and investment in productive capacity is a critical factor in a growing world.”

The key problem for OPEC is that they and non-OPEC live in two different worlds: the realists, OPEC, deal with the static world when it occurs, and the optimists, non-OPEC, forever invest in the growing one.

The charts below show this has had a major impact on OPEC’s  contribution to global demand growth:

Global Oil Production, Consumption and OPEC / non OPEC Output, 1965-2015

source BP

As the first chart shows, when global oil demand has faltered, OPEC has taken the brunt in output cuts because it has the most to lose: national budgets versus diversified corporate profits. It also has a greater ability to respond, due to the flexibility of its oil fields, and the coordinated governance of its national oil companies (NOCs).

For non-OPEC, only viewing the long cycle, the world has always grown, and so will continue to grow. Hence, investment in productive capacity is more than a strategic choice: it is a raison-d’etre, and it has become a pathology of the international oil industry.

In addition, having inflexible production, and long investment cycles, non-OPEC producers have tended to downplay short-and medium-term price movements.

The second chart shows that these two factors: OPEC leadership on cuts, and non-OPEC’s continuous investment growth, have increased non-OPEC’s average share of global demand growth.

OPEC and non-OPEC Share Incremental Oil Growth: 95-05 and 05-15

source BP, Energy Outlook 2017, slide 28, dollarsperbbl analysis

And non-OPEC’s strong-form investment policy will continue.

For example, BP’s view of future demand, below, is typical of the non-OPEC sustaining investment narrative: it’s latest base case assumes demand growth beyond 2050, perhaps far further.

In the past, OPEC had been able to deal with this, as non-OPEC’s determined, but slow response to demand recovery allowed supply overhangs to be cleared relatively quickly.

But this has changed.

Non-OPEC supply has not only increased in scale and diversity, it has also increased in speed, with the addition of the manufacturing methods such as US shale.

In the latest downturn in 2014, non-OPEC capital outlay and production did take a short step back. But it has returned quickly, with US shale leading a major revival in production.

source: FT

OPEC  have therefore upgraded non-OPEC production forecasts for 2017-18 by an extra 1 million b/d. Goldman Sachs have also noted how the previous high investment cycle will lead to new production in 2018 onwards.

Announcements by BP, Shell, Chevron, Exxon and others also indicate a strong pivot toward faster production plays such as the US Permian.

Skeptics such as the IEA suggest that non-OPEC’s reduced investment in major projects present a future supply crunch. But the non-OPEC industry is quicker off the mark than that: megaprojects may have been cancelled, but that has just forced companies to switch to other routes of production. With the likes of US shale and brownfield tie-backs of their vast portfolios, these routes are also more rapid and lower cost.

Mabro formed a view of how an eternal investment strategy would play out:

“An investment race pursued blindly can have similar effects to those of a price war. There is an important difference, however. In an investment race the front runners improve their market shares before the subsequent price collapse which occurs if new capacity exceeds growth in demand. In a price war the leaders improve their market share position after the subsequent price collapse. “

Non-OPEC’s relentless investment race, along with OPEC’s tactical production cuts, is ceding market share year by year to non-OPEC producers. As long as OPEC maintains a price floor, an OPEC put option if you will, non-OPEC’s investments continue, improving their market share.

Even as a price collapse looms, non-OPEC’s strategy will continue, gathering up the market share that OPEC will be unable to re-capture as it would lead to a price war that it could not sustain.

Demand is the Decider: non-OPEC’s Dominance of a Declining Market

The one remaining question mark is the future strength of oil demand. First to note, the average trend is already downward, with OECD demand negative and non-OECD demand growth decreasing – these are oil company forecasts as well as industry views.

How negative and how quickly is debated, but investment levels in electric vehicles, and the efficiency gains in most other forms of oil consumption indicate that the average consumption will drop below 1 million b/d over the next few years, and decline far quicker if new technologies enter a hyper-growth phase.

For the purpose of OPEC’s options though, a high probability of demand weakening is the critical point.

The chart below therefore assumes that in 2015-2025 oil demand averages growth of 0.7 million b/d (BP assumption), and that non-OPEC supply grows at 0.8 million b/d based on current near-term growth forecasts from EIA and OPEC of 1 million b/d 2017-18, then averaged lower over the period (note BP see non-OPEC growth of about 0.4m b/d over the period, this is where we disagree).

OPEC / non-OPEC Share Oil Demand Growth Historic and  2015-25 est

In this scenario, OPEC growth is permanently negative – a long-term production cut – because OPEC will need to cede supply growth to non-OPEC volumes in an attempt to maintain prices (more precisely, revenue per capita).

In fact, irrespective of oil price movements, OPEC is likely to have to concede market share, as non-OPEC’s investment volumes continue to absorb declining market growth.

OPEC’s Final Choice

Mabro’s lessons from 1998 indicate that OPEC cannot pursue a market share strategy, and that they are doomed to perform production cuts when required.

He also noted that once front-runners, in this case non-OPEC, establish a lead in investment, they can consolidate market share before prices collapse.

If OPEC view the latest demand downturn as only cyclical, they will retreat to a smaller global share via production cuts – a position they may never be able to reverse. Their cuts may become permanent.

If, however, they view the downturn as structural, they now have to consider what they want to be in the future oil market: minority price-takers, or market leaders via a major shift toward share dominance.

The market share approach is extremely high risk, and would involve unseating the investment juggernaut that is non-OPEC. It is a strategy still open to them as we noted in this post, but the effort and costs involved look increasingly challenging.

Far more likely, with the Aramco IPO ahead, and a belief in a demand upturn, OPEC will choose to look at the near-term and extend and deepen production cuts. This will however allow non-OPEC to relentlessly expand investment and output, and capture more market share.

The consequences for OPEC are large: a further cut will relegate their position in the market permanently, and force downsizing and diversification. Their asset base then looks increasingly stranded.

For non-OPEC, they inherit dominance of the global market, but one that is in decline.

So future cuts will be unlikely to  happen via the intrigue and drama of Mabro’s 1998 adventures: but rather through the cold calculus of market demand.

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