For 30 years, OPEC has been busy manipulating the price of oil towards whatever deviant objective is on their minds. They’ve been pretty good at it, but the recent oil price collapse has led to a general conclusion that OPEC is dead, that shale oil production has robbed the cartel of its power.
This near-uniform consensus is reminiscent of the sheep-like positive view of the US housing market circa 2006, and it may well have consequences that are just as severe. OPEC has finally and inadvertently given us clarity on their legendary surplus capacity, and it’s an eye-opener. For years, we’d been told that OPEC stood ready to meet any supply shocks with readily available barrels. But we can now see that OPEC’s self-declared supply cushion should provide all the comfort of a knock-off airbag.
We have finally been able to see the picture clearly because of OPEC’s recent policy reversal. Their current strategy, unveiled in November 2014, justifiably made a lot of headlines because it perfectly contradicted the public statements they had been making up to that point. The reversal was of course OPEC’s decision to immediately cease caring about oil prices. For decades, OPEC acted like some demented steward of the world’s economies, adding or subtracting production at will to achieve what they considered to be a “fair price.” This fair price bounced around a lot depending on how poor OPEC felt, and what they thought they could get away with. It also wreaked havoc on global economies, boosting those of oil producers and crippling those of net importers. No one at OPEC headquarters cared much, Members really liked using the “fair price” term, almost to the point of absurdity; any figure between $20 and $100 per barrel earned the tag depending on what they thought they could get away with at the time.
When OPEC stopped the fair price nonsense in 2014 and announced that a world flooded with oil was just fine with them, prices plummeted. The quick analysis was that the rise of shale oil production had so rattled OPEC that they needed to stop its growth in its tracks. This view was possibly correct (though quite a few other theories were proposed, such as that Saudi Arabia was trying to harm Iran or Russia or Bangladesh or something, but that speculation was of course hopelessly hypothetical). But the inference was made that shale production gains were so rapid, endless and unstoppable that a few US shale basins now controlled global production, and that the US was now the new “swing producer.”
The notion that the US was the new swing producer caught on admirably, but those who subscribed to the theory clearly had no idea what the term meant.
A true swing producer is one that tinkers with production levels in order to maintain a certain market equilibrium or price. A swing producer can either raise or lower production as required. That’s not the case with the United States. US shale producers are beholden to capital markets that demand growth. Witness their current behavior – five hundred rigs are still drilling for oil while the world’s oil tanks are bursting at the seams and producing companies are going bankrupt left right and center. Does that seem like the behavior of a swing producer? US oil production will fall, but not because anyone made a choice to “swing” production. It will fall because banks won’t lend anyone a nickel and equity investors are largely shunning oil stocks like plague-ridden rats.
But even if US shale production revives, it isn’t the big deal that localized media makes it out to be. US shale production only makes up a fraction of the global total, and people forget that. OPEC produces about 32 million barrels per day out of a global total of 94 million. Total US production reached a multi-decade peak in 2015 of just under 10 million barrels per day, and shale production accounted for about half that. In other words, OPEC can wipe out the entire effect of the US shale revolution by shutting in less than 1/6 of its production, as they’ve done in the past. They still could shut in those volumes and drive prices to the moon, and that fact should silence the nonsense about OPEC being a spent force. But they won’t, because OPEC is determined to quash a lot of high cost production, and they are succeeding at that. The world is simply moving to a point where the price of oil will determine how much oil is produced rather than random OPEC decisions, and that’s the really interesting part that is being overlooked.
It is becoming obvious that OPEC has duped the world with respect to what they can produce. We believed for decades that OPEC had a comfortable spare supply cushion they could turn on at any time if there were production-hobbling catastrophes anywhere in the world. Why did we believe that? Because OPEC said so, over and over again, and everyone simply believed them. For years, OPEC insisted that they had millions of barrels per day of extra production available whenever needed, so there was never any need to worry about silly little wars, earthquakes or what have you, don’t worry because Uncle OPEC will take care of everything.
But since November 2014 we’ve found out that Uncle OPEC was a charlatan. We can now clearly see that the OPEC supply cushion was a myth, or at best grossly overstated. OPEC is now producing flat out, because that is their strategy – to flood the market, drive down prices, and debilitate high cost areas like shale oil and oil sands. Saudi Arabia has, for the past year or two, had more rigs drilling for oil than in the past 20 years. Yes, production has increased, and yes, the market is flooded. But nowhere near the levels that OPEC implied. And to think they are producing less than the maximum is kind of irrational given that their plan is to flood the market as soon and thoroughly as possible.
What is important to remember though is that in the event of a war or some other catastrophic event that severely crimps oil production somewhere in the world, there is no help on the horizon. We have long been told there was, but it’s demonstrably not true now.
This should be a sobering thought for anyone that is banking on low oil prices to last indefinitely.
Read more insightful analysis from Terry Etam here