Toward a Better Understanding of Oil Markets
January 26, 2015
The rapid drop in oil prices over the past six months has spawned a wide range of (at times, conflicting) conspiracy theories on how and why oil prices are falling. While these theories are creative and intriguing, we contend that market watchers would be far better served by analyzing the fundamentals of supply, demand, economic performance, and cost competitiveness to understand the basics behind this dramatic decline. Of course, market “psychology” always plays a role, including the tendency to overshoot and then correct, and a bit of history can be instructive as well.
For starters, though persistent supply growth has been heralded by many as “the story” of 2014, we continue to believe that last year’s real surprise was the demand that failed to materialize—some 600,000 barrels per day short of expectations by some forecasts. After three years of consistently robust supply growth, mostly from North America, at prices of $100/barrel, expectations for continued success were high—and did not disappoint. By mid-year however, the signs of ebbing global demand growth were already becoming evident. Once the fundamentals of supply and demand reasserted themselves, the overhanging surplus in the face of anemic growth (even with considerable geopolitical uncertainty) caused the onset of a marked price decline (some $65 since last summer) that has characterized the past six months.
Last September, we published a “troubles ahead” commentary forecasting the consequences of continued oversupply/insufficient demand and explained how, given the overhang, even modest new demand growth was unlikely to rescue producers from a lower price future at least in the near term. We contend that the points raised in that analysis remain true today and that such market-oriented explanations trump conspiracy theories (e.g., Saudi Arabia and the United States are colluding to hold prices down to punish Russia and Iran, or Saudi Arabia has declared open war on U.S. tight oil development) and explain the OPEC/Saudi response to current and emerging competition in a low demand growth environment.
The Context for OPEC Nonaction
In both the run-up to and the weeks following last November’s OPEC meeting, it was increasingly evident that Saudi Arabia (supported by Kuwait, UAE and Qatar) was unwilling to unilaterally shoulder significant production cuts in order to prop up prices and facilitate alternative production sources—regardless of origin—in gaining market share. Despite media reports to the contrary, no other producers stepped forward to offer cuts to help stabilize prices, and if they had, the maintenance of a higher price level would have only exacerbated the oversupply situation, in essence replacing lower cost production by subsidizing expansion elsewhere. This is true both within and outside of OPEC, whose ability to function as an effective price-setting cartel has not been in evidence for years. The reality is that Iran, Iraq, Nigeria, Libya, and Venezuela would love to be able to increase rather than restrict output. The same is true for Russia as well as other non-OPEC operators.
As a large producer/exporter and the globe’s major holder of spare capacity, Saudi Arabia has been criticized in some quarters for rejecting calls to reduce production in order to put a floor under prices, but a look at the facts conveys a more nuanced reality. In the wake of the 2010 price rise, increases in U.S. and Saudi production helped offset losses in Iran, Iraq, Nigeria, Libya, and elsewhere and kept prices from rising higher and jeopardizing the global economic recovery. In the past few years, Saudi oil production has been remarkably stable, varying by 1–2 percent. Last year, Saudi crude oil exports declined, but these reductions are at least partly attributable to the ramp-up in domestic refining projects within the kingdom and the result of reduced exports to the United States (due to the increase in U.S. production) and China (where volumes from Iran and Iraq have eroded Saudi volumes and market share). Is it any wonder that the kingdom or other lower cost producers would balk at calls from competitor nations to cut output and allow higher cost production to capture sales and market share, especially in the current market environment?
An Historical Perspective
Taking a longer historical view, it is interesting to note that OPEC production in the second half of the 1970s averaged about 30 million barrels per day (mmb/d), roughly comparable to what the group supplies in today’s market, but of course since that time individual producer country shares have varied widely. In 1979, Iran, Iraq, and Libya collectively produced almost 13.5 mmb/d. Today, as a result of both internal strife and decades of externally applied sanctions, they produce less than half that amount.
In the early to mid-1980s, OPEC exports and market share fell precipitously from more than 30 mmb/d to 16 mmb/d. During that time, Saudi output was more than halved from over 9 mmb/d to 4 mmb/d. As a consequence, in an attempt to win back market share and remain competitive, the kingdom introduced net back pricing. It now prices its crudes to be competitive against similar quality oils in various markets.
In late 1985, reacting to the (ongoing) price decline and oversupply conditions, OPEC’s Geneva meeting produced, among other things, a call for a global sharing of the pain caused by the price collapse. Saudi Arabia’s then-oil minister, Sheikh Yamani, was quoted as noting that in order to prevent a further price collapse, “… non-OPEC exporters will have to give up part of their market share.” In the intervening decades, OPEC’s output has remained relatively constant, but its share of the market has declined from two-thirds of world consumption to roughly 30 percent.
Cohesion within OPEC
Fissures within OPEC have been evident and growing for years. Producers such as Iraq, Iran, Nigeria, Venezuela, and Libya, who have experienced production declines or stagnation due to sanctions, political unrest/instability, or sabotage, now believe themselves “entitled” to regain market share and grow their output. Saudi Arabia, which has consistently performed to meet market needs (including the investment in and maintenance of spare capacity) feels it has earned its role and market position. And now, a variety and potentially growing list of aspiring new producers are looking to make their mark—all in a limited growth environment.
In many instances, beleaguered producers—both OPEC and non-OPEC nations—are also desperately in need of new revenue streams to address the needs of growing and sometimes restive populations and government priorities, a situation only made more dire by a 60 percent drop in prices. Further, divisions within the OPEC membership now also include crude quality (e.g., the light oil producers already displaced from U.S. markets due to the surge in domestic light tight oil and now desperately in search of Asian buyers versus the heavier oil suppliers), religion (Sunni-Shi’a disputes), and state/regional competition. In addition, China’s loans and market entry into selective countries (e.g., Africa, Venezuela, Iran, Iraq, and now Russia) further complicate a changing market landscape. Ironically, given current demand projections, growth in OPEC oil volumes are more likely to provide a ceiling on prices rather than a floor.
The Surge in U.S. Unconventionals and What Lies Ahead
Finally, despite the extraordinary surge in unconventionals production and new status as the largest oil and gas producer in the world, the United States remains a net importer of petroleum. In the coming months, the continuation of low prices will unquestionably test the resiliency of the domestic oil and gas sector. Lower commodity and stock share prices are already translating into reduced (and refocused) operating/drilling budgets. Regulatory restrictions and infrastructure issues present additional challenges. For all the analysis and hype, there is no meaningful “average” break-even or shut-in price for U.S. output. It varies by basin, by producer, by maturity of project, attendant infrastructure, cash flow and credit worthiness of investors, regulatory, capital and operating costs, refinery configurations and demand, and market forces both here and abroad—just to name a few considerations. Further, to the extent individual producer resiliency in the face of lower prices proves to be widespread, the continued and expanded oversupply will only worsen the economics for everyone. We saw this happen with the surge in growth of domestic shale gas volumes only a few short years ago.
It may be that the combination of greater demand growth and reduced supply (occasioned by lower prices or geopolitical events) brings the market back into balance in the second half of 2015 (or more likely, perhaps, 2016), but we cannot count on that eventuality. It also may be that cost reduction and technology improvements actually make production more resilient to lower prices. If history is any guide, unless demand roars back or significant and severe supply cuts are able to both absorb the overhang and accommodate new supply that eagerly waits in the wings, the experience of relatively stable albeit higher prices seen from 2010 to 2013 may look like the outlier, and we may well be entering an era of more modest prices.
But be forewarned, persistent and extended low oil prices sow the seeds of a multitude of outcomes, near and longer term, and not all are beneficial. Commodity cycles move up and down, and lags in new investment frequently portend upward price adjustments as demand recovers and grows. For now, consumers will benefit from lower fuel and energy prices generally. Trade balances will balloon or recede. National GDPs will improve or decline, depending on which side of the producer/consumer ledger nations are on. As U.S. consumers see savings in gasoline prices, in aggregate, producers stand to lose up to $1.5 trillion this year, and technical energy jobs are significantly higher paying than other service sector positions. In addition, future investments, technological improvements, fuel choices and availability, national sovereignty and stability, climate change, efficiency and potential geopolitical realignments all stand to impact and in turn be impacted by the trajectory and duration of oil’s price decline. And as we’ve stated before, underinvestment in a depletable resource inevitably leads to price increases further down the road.
Frank Verrastro is senior vice president and holds the James R. Schlesinger Chair for Energy and Geopolitics at the Center for Strategic and International Studies (CSIS) in Washington, D.C. Guy Caruso is a senior adviser with the CSIS Energy and National Security Program. Lawrence Goldstein is a senior associate with the CSIS Energy and National Security Program and a trustee of the Energy Policy Research Foundation.
Commentary is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).