Reality Check For Opec

Donald Trump says he wants the US to be energy-independent. Opec should take heed

Patrick Heren

After two years of decline, the oil market is enjoying a period of mildly bullish sentiment. Prices rose from a low of $26 a barrel early in 2016 to just over $50 in late October. The proximate cause is Opec’s decision to curb production in order to support the higher prices its members need to balance their national budgets. The trend should be treated with caution.

Opec in and of itself is a most ineffective cartel. Its market power principally resides, as it has always resided, in Saudi Arabia’s swing production — the ability to raise or lower output in order to defend a particular oil price. This is a role the Saudis have always regarded with a reluctance bordering on distaste. Two years ago they abandoned it altogether in favour of maintaining a steady level of production that did not commit them to maintaining the high prices required by their non-Opec competitors (principally major oil companies and US shale drillers). That policy helped cut the price from $110 to as low as $40.

It is worth emphasising that not only do other Opec members not share Saudi Arabia’s swing ability, but over the years most of them have proved themselves incapable of sticking to production quotas agreed, invariably with great media fanfare, at ministerial meetings. Not to put too fine a point on it, most Opec members are inveterate cheats. Two of the most important, Iran and Iraq, are rebuilding their export capacities after many years of warfare and embargo, so will not stick to any number they may have put their names to at Opec. As for Russia, which allowed itself to be flirted with by Opec, any idea of oil export cuts is laughable.

Any sharp increases in the oil price — say to $75 or more — will be short-lived. That is because the US shale industry has adapted adroitly to the challenge posed by lower prices and can now produce profitably at $40/bl. And the US has lifted export controls (originally imposed after the first Opec challenge of 1973/74) allowing American crude to flow into the world market.

By unlocking the vast riches trapped in shale rock, fracking has changed the nature of the oil industry. Shale oil and gas are essentially manufacturing businesses with well-defined resources and costs. Because the resource is well understood, the process is largely de-risked, especially compared to the traditional risk-based exploration and production business. Producers make swift decisions based on costs and prices. Currently it is confined to North America, but it must inevitably spread to other regions as well.

President-elect Donald Trump has said he will do everything possible to encourage further shale oil and gas development to make his country fully energy-independent. His chief energy advisor is Harold Hamm,  chief executive officer and majority  owner of Continental Resources, a US shale oil producer.

 That is the new reality that Saudi Arabia and its unreliable comrades in Opec have begun to face up to. They can produce to a certain price, but they no longer have the ability to push it beyond the marginal cost of shale oil in the United States.

The bottom line is that, absent major supply disruptions (war in the Middle East or North Africa, for instance), the oil market is likely to settle around $50 (+/- $10) for the foreseeable future.

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