The Fuse

This Is What a Free Oil Market Looks Like

by Matt Piotrowski | August 25, 2015

There’s been a lot of talk about so-called “wars” in the oil market. In particular, much discussion has surrounded OPEC’s war on shale and OPEC members waging price wars with each other. There’s also been a string of headlines about who has won and who has lost with oil prices collapsing. But there are no “wars” going on in the market, and all producers are being hit one way or another with West Texas Intermediate (WTI) plummeting to $38 and Brent to $42. Once one gets beyond the noise, it’s clear that the oil market is now functioning the way a free market should: Numerous buyers and sellers are competing with one another in the marketplace, weeding out wasteful resource allocation and causing prices and costs to fall.

The current market is unimpeded by a cartel to curb supply to shore up prices. Before the OPEC meeting in November of last year, the producer group would, for the most part, manage supply levels to keep prices artificially inflated.

The current market is unimpeded by a cartel to curb supply to shore up prices, a paradigm that the market has not dealt with for decades. Before the OPEC meeting in November of last year, when members did not take action to cut output, the producer group would, for the most part, manage supply levels to keep prices artificially inflated. That’s not the case now with the group virtually pumping all out, and possibly more on the way from Iran, Libya and Iraq.

Recent discussion has mainly surrounded Saudi Arabia, the de facto leader of OPEC and the only producer with significant spare capacity. Its strategy of producing at high levels despite weakening prices is twofold: To hold onto market share and avoid subsidizing high-cost non-OPEC production. This approach is not necessarily aimed specifically at putting U.S. shale producers out of business; instead it is to protect the kingdom against new production—whether it is shale, deepwater, or subsalt—and additional conventional supply from its counterparts in OPEC.

Saudi Arabia’s strategy of producing at high levels despite weakening prices is twofold: To hold onto market share and avoid subsidizing high-cost non-OPEC production.

In the late 1970s and early 1980s when OPEC cut output to support prices, the group essentially helped spur new production in places such as the North Sea and Alaska. This supply growth eventually caused prices to stay low for an extended period. Similarly, by OPEC manipulating output to support prices for part of this decade, it distorted the amount of investment on the supply side and created an environment in which shale producers could enter the market. Given the barriers to entry for small players and the high costs associated with hydraulic fracturing, the high price of more than $100 from 2011-2014 stimulated the U.S. shale boom and technological developments on the supply side, which ultimately led to the current glut and low oil price.

The Saudis do not want similar developments to the 1980s or the first part of this decade to take place again.

Others are also more concerned about market share than price. Iran, for instance, will still add supply to the market in the coming months even with the risk prices may go lower. “We will be raising our oil production at any cost and we have no alternative,” Iran’s Oil Minister Bijan Zanganeh said. “If Iran’s oil production hike is not done promptly, we will be losing our market share permanently.”

Have the Saudis really ‘lost’?

One main factor prompting commentators to say the Saudis have “lost” to the U.S. is the kingdom issuing bonds worth 20 billion riyals ($5.33 billion) and needing to issue more in order to maintain its spending plans. But the Saudis, who may be in the strongest position to ride out an extended period of low prices, aren’t the only ones getting hit in this environment. The Russian ruble continues to deteriorate and Moscow says the economy will contract this year; Venezuela is on the brink of default; U.S. shale producers have laid off workers and some have resorted to selling oil fields to raise cash; the majors are cutting costs and delaying new projects; and steady oil-producing countries such as Canada and Norway are seeing fiscal strains.

Another issue prompting talk of the demise of the Saudi plan is the fact that U.S. production has remained resilient amid lower prices. But U.S. output has fallen lately, from 9.6 mbd to 9.35 mbd, and if the Energy Information Administration (EIA) is correct in its projections, production will dip below 9 mbd next year, tightening fundamentals, or at least keeping the surplus from ballooning even more. Whatever the case, under the current circumstances, free market dynamics—and how producers react to price signals—will ultimately determine the fate of U.S. shale, not OPEC policy.

Consumer benefits

Free markets are, in theory, supposed to foster competition and benefit consumers. That is occurring now, with motorists in the U.S.—the world’s largest consumer and the market where pump prices are closely tied to global oil prices—experiencing billions in savings. Moreover, China, the main pillar of oil demand growth over the past decade or so, is using the low-price environment to mop up volumes to grow its commercial and strategic stockpiles.

Free market to remain intact?

Producers and consumers will continue to watch a free market play out before them, making the price outlook as uncertain as ever.

A number of factors could ultimately turn the market around, including a slew of new geopolitical outages, high-cost wells shutting down in rapid succession, or higher-than-expected demand growth. All appear unlikely in the short run, however. A coordinated OPEC output cut would be the quickest way to alter fundamentals and support prices. The group has been effective in the past. Slicing output in the late 1990s when prices fell to $10 per barrel and in December 2008 when the market lost $115 in just five months are two key examples.

Some OPEC members, wanting to replay the late 1990s or 2008, will keep calling for emergency meetings, and commentators will continue to suggest that the Saudis listen to others in the group, but these developments appear doubtful in the near term. In the meantime, producers and consumers will watch a free market play out before them, making the price outlook as uncertain as ever.