The Fuse

OPEC Is Down, But Not Out. Here’s Why

by Matt Piotrowski | December 09, 2015

With OPEC failing to take action to support prices and its members unable to establish any kind of production target, is the cartel finished for good? A lot of pundits sure think so. Jim Cramer on CNBC said, “There is no cartel. The cartel was meant to keep the price controlled. They ended the cartel, and that’s why this is happening.”

One commentator on Seeking Alpha summed up the sentiment of a lot of market watchers: “OPEC is no longer relevant. Yes, journalists will target their meetings. Traders and trading algorithms will still scout for hints of increasing/decreasing production. The organization will still supply the world with its oil market report, providing its view on the oil market to the market participants. All this will still be present, but the most important thing is lost, and, likely, lost forever—pricing power.”

OPEC has faced a number of existential threats ever since its creation in the 1960s, and there have been premature obituaries written about the cartel many times before.

Is OPEC really finished for good? Not in the least. It has faced a number of existential threats ever since its creation in the 1960s, and there have been premature obituaries written about the cartel many times before. But OPEC has always eventually turned itself around, whether on its own volition or because of market circumstances, and influenced the oil market in dramatic ways. Even though it’s hard to imagine with the current situation of full storage tanks, $30 oil, and resilient U.S. shale supply that OPEC could become relevant again, the group still matters longer term: It will reaffirm itself, as it has in the past, when fundamentals shift and members gain a stronger grip on the market. OPEC countries hold some 80 percent of the world’s proven crude oil reserves and make up about 40 percent of the world’s current supply (when natural gas liquids are included), so they will be important players in the global market for years and decades to come. And in many ways, the longer that low oil prices persist, the greater OPEC’s ability to reassert itself in the future.

Opecchart

OPEC’s market share has always been cyclical and is a major determinant for its pricing power.

OPEC’s market share has always been cyclical and is a major determinant for its pricing power. For instance, in the 1980s, when the market crashed, the group’s share of global demand fell from above 50 percent in the 1970s to below 30 percent. But it slowly re-established market share throughout the late 1980s and the 1990s, allowing it to eventually take action to prop up prices. The high price environment during the 2000s and 2011-14 stimulated large increases on the supply side, puncturing the market and causing OPEC’s share to plummet once again. Against this backdrop, the current weak prices will allow it to recapture a higher portion of global demand.

Turbulent times before

Throughout the 1980s, 1990s and 2000s, the cartel appeared, like today, no longer relevant.

OPEC has had to ride out turbulent times from a variety of facors, including low prices from new supply in the North Sea and Alaska in the 1970s and 1980s, along with government programs for fuel efficiency and alternative fuel sources such as biofuels. “Saudi Arabia believes that the price war eventually will eliminate much oil from non-OPEC producers, such as Britain and the United States, because their oil is too expensive to produce,” the Wall Street Journal reported on June 30, 1986, but this could easily have been written after the latest meeting.

An extended period of low prices which culminated in prices falling to $10 per barrel in 1998 seemed to be a clear sign that OPEC had become powerless. Saudi Arabia had orchestrated a production increase in Jakarta in 1997, but the output hike occurred at the same time demand took a hit from an economic downturn in Asia.

The Economist told its readers to welcome the end of OPEC’s power.

Instead, the “ghost of Jakarta” haunted the organization for the next decade, making the group vigilant in defending the market on the downside. In 1998-9, the cartel, in collaboration with some non-OPEC producers, sliced output, helping set the stage for the bull market of the 2000s, when prices ultimately reached $147.

The “ghost of Jakarta” haunted the organization for the next decade, making the group vigilant in defending the market on the downside.

There was also a lot of talk during the price rise from 2004-8 that the cartel had lost control of the market. Even OPEC ministers admitted the group was powerless to arrest the rapid rise in prices amid its low spare production capacity. But once prices crashed in the wake of the financial collapse, OPEC members came together quickly to cut by a total of 4.2 mbd to keep further losses from occurring and support the market. The action worked well. Although Brent fell to $40 in January 2009 soon after the group announced its decision to throttle back, the oil price reached $80 a year later and then hit triple digits at the beginning of 2011. Recovering demand after the 2008 financial crisis helped lift the market, as did the beginning of the Arab Spring in 2011, but if OPEC had not agreed to cut output, the market would not have rallied as fiercely as it did.

OPEC to increase market share over time

Besides their massive resource base, the main advantage for OPEC countries over the longer term is low-cost production. The current price environment threatens expensive shale production and megaprojects that have long lag times and are capital intensive. Upstream investment has been crippled by cancellations and deferrals, while waves of layoffs and cost-cutting measures could hamper the industry for decades.

OPEC’s market share is expected to rise from 41 percent in 2014-2020 to a startling 49 percent two decades later, close to levels seen in the 1970s, when the group reached its peak.

While U.S. shale output has been a so-called game-changer for the oil market, it doesn’t necessarily bring about solutions for the longer term outlook. Non-OPEC supply is forecast, according to the International Energy Agency’s (IEA) World Energy Outlook, to decline after 2020. At the same time, OPEC’s supply will continue to grow, and the cartel’s market share will naturally rise. One key takeaway from the WEO, which was often overlooked as the main focus was on the agency’s $80 forecast for 2020, is that OPEC’s market share is expected to rise from 41 percent in 2014-2020 to a startling 49 percent two decades later, close to levels seen in the 1970s, when the group reached its peak.

“If non-OPEC production starts declining, then prices go back up, and the Saudis will have the capacity to influence the market,” Jean-Francois Seznec, a leading Middle East scholar and a Senior Fellow at the Atlantic Council’s Global Energy Center, told The Fuse.

All OPEC members are set to see production increases throughout the coming decades—although how successfully they boost capacity depends on how each country manages its resources and geopolitical risks. The largest increase will come in the Middle East, led by Iraq and Iran, with output growth of 1.2 percent per year, for a jump of 10 mbd, or an enormous 37 percent, for the region.

Saudi strategy will work, eventually

“The organization is under the thumb of the Saudis. They have a lot of power. Nothing happens unless the Saudis want it to happen.”

The current turmoil in the group stems from members such as Iran and Venezuela unhappy at the Saudi-led strategy of taking a “wait and see” approach toward the current market. It’s important to note that, ultimately, the direction the organization takes at any time is dependent on the Saudis, and their political goals and their view of the market.

“The organization is under the thumb of the Saudis,” said Seznec. “They have a lot of power. Nothing happens unless the Saudis want it to happen.”

Seznec notes that the Saudis’ goal now is not to build market share, but rather to make the price rebound back to $80 per barrel, whether through coordinated cuts with Russia or curtailed growth in non-OPEC supply.

“What’s the point of having large market share if you’re producing at a low price?” said Seznec.

In 1998, the Saudis drowned the global oil market in order to force others to cooperate, within OPEC and outside the organization. Eventually, a series of production cuts emerged among both OPEC and non-OPEC producers, which helped triple the price of oil over the course of a little more than a year. Saudi Arabia’s Oil Minister Ali al-Naimi has repeated that the Kingdom would go along with output cuts if non-OPEC producers participated. Just like in the 1990s, it simply does not want to shoulder the burden of being the only producer to cut output.

Whether action similar to the 1998-9 cuts happens in the coming years is up in the air, and may in fact be far-fetched. But even so, there are still lessons to be learned from the 1998 price crash. The market eventually rebounded, and it did so with a vengeance, making much of the commentary, such as the Economist’s prediction that OPEC was finished, look foolish in hindsight.