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Inside, confidential and off the record

OPEC 's dilema

As we all know, oil prices recently have kissed “good bye” to a record period of high and stable prices. For 45 months, since the beginning of 2011, prices have remained at record highs (there never was such a prolonged period of above $100 oil prices before) and price volatility at record lows (the lowest annual price volatility since at least 1970 when prices were no longer posted). Now they have fallen by almost 30% in a matter of weeks.

You may recall the basic story behind this period of stability – and why it really reflected a period of “eerie calm”, but not of stability in any meaningful sense (you may go here to recall it in more detail).

I concentrate on the supply side because this really is a story about supply, and an amazing one at that. The long apparent calm in oil markets never reflected a stable environment because it was the accidental outcome of two opposing, different and in principal unrelated forces – with huge (by historic standards) supply disruptions in North Africa and the Middle East neutralizing equally relentless (and no less historic) oil production growth in North America.

This is the tale of major supply disruptions accidentally offsetting historic US production growth. On the face of it, there was no reason for stability: Uneven demand growth aside, global oil markets have been in turmoil since the advent of the “Arab Spring”, since the start of the Libyan civil war in February 2011 caught between mounting supply disruptions in North Africa and the Middle East and equally rapid production increases of “unconventional” oil in North America.

Over almost four years, supply disruptions have mounted in North Africa and the Middle East. By the summer of 2014, cumulative disruptions from the countries denoted in the graph alone had reached an extraordinary 3.5 Mb/d – easily the largest involuntary outage since the collapse of the Soviet Union coincided with the Iraqi invasion of Kuwait in 1991.

Meanwhile, the shale gas “revolution” in the US spread to oil production, in the event generating the highest annual production increases the US has ever seen. In terms of “organic” growth, based on genuine capacity expansion (i.e. excluding periods where producers could rely on existing spare capacity), last year's US increase was the fourth biggest increase in the history of global oil markets. And so far, US tight oil production continues to rise.

So many moving parts would normally lead to a period of great price volatility, as these moving bits and pieces adjust to each other.

They didn't, because the production increases in the US were neutralized, almost barrel for barrel, by supply disruptions in Africa and the Middle East. Even the time profiles look identical. If a difference occurred between aggregate (global) supply and demand at all, it was rebalanced by Saudi Arabia, which during this period returned to its traditional role as a swing producer.

Oil markets today would look very different without this accidental match: Had we witnessed only supply outages on the scale they actually happened, we would have seen prices spiking; and had we seen only the progress in shale production on the scale it actually happened, prices would have come under pressure much earlier.

At its heart, this stand-off is, of course, a coincidental one. Higher prices may in good time induce more shale production. But virtually nothing else of logic or substance connects the two developments. And if two developments neutralize each other by chance, it is safe to assume that the impasse will not last. The question always has been which side in this stand-off would gain the upper hand – and when.

In the event, it was rebounding Libyan production which tipped the balance this Fall.

No doubt, this latest recovery in Libya is fragile and can reverse any day. On balance, however, the production outlook for US shale oil (at current prices!) is poised for firm growth until beyond 2020. It is hard to see how the current chain of involuntary disruptions could continue to keep pace with this forecast for years to come, short of escalating major disasters. This indicates the probable direction of travel: Eventually, North American production growth is likely to outpace the unusual scale of disruptions which have neutralized its effects for so long.

If this is correct, the current situation of oversupply in global oil markets is likely to be with us for a little longer. Whatever the future holds, even the present situation leaves OPEC now with a seemingly simple choice – to cut production or not to cut production, and to accept lower prices for what looks likely a sustained period of time.

The argument for production cuts is to bring prices back up. The argument for leaving production levels broadly intact traditionally may have been to lend support to a fragile global economic recovery – and hence oil consumption growth. However, increasingly a second argument has gained currency, namely to maintain production in order to undermine price sensitive American shale oil growth, which would be hurt by lower prices. How price sensitive US shale oil (and Canadian oil sands) are is today's multi-billion Dollar question (quite literally). It is this second idea that is the relevant strategic consideration today.

Can it be done?

Current cost for unconventional oil production varies between $80-85 per barrel for Canadian heavy, and $60-65 or below for US tight oil plays. But we know that in oil markets, if the price falls, costs will follow. Oil prices thus would have to remain appreciably below 2011-14 levels to have an impact on tight oil production.

But there is another unknown: a technical difference between the well density of tight oil and conventional oil production. It takes a large number of wells to produce volume at scale from shale oil whereas “conventional” oil (offshore or onshore) can generate huge volumes from single wells. Technically, it is therefore relatively easy to scale shale oil production up or down (starting with the most expensive wells); this is not the case for conventional production, which offers more of a binary choice. Because output is easily scaleable, a decline in prices is likely to trigger a gentle and flexible response from shale oil, scaling down production volumes gradually –with the option of bringing them back up gradually as soon as prices rise again. Recent developments in shale gas, with low prices slowing down dry gas supplies very gradually, have shown these mechanics at work.

A comparison provides an example of the consequences. In the 1980s, new supplies from the North Sea and Alaska had come onto the market on a scale not dissimilar from today's increase in shale oil. When prices reacted and fell dramatically, the companies running these facilities saw themselves confronted with an almost binary choice: To shut in production, or to accept lower prices. Faced with the need to generate cash flow, they choose the latter, in the event accepting a massive need for internal cost cutting. Prices remained low for a decade and a half.

OPEC then faces a dilemma. Either production is cut and prices stay at high levels – which means key members are likely to continue to lose market share to expanding shale output. Revenues would suffer. According to BP's Energy Outlook 2035, cuts would have to be substantial to keep prices up, creating spare capacity of up to 6 Mb/d before the end of this decade and before OPEC's market share will rise again.

Or production is not being cut – which would translate into a prolonged period of lower prices to deter shale oil production from bouncing back as soon as prices rise again. In this scenario lower prices should last – until global demand has picked up sufficiently to allow for OPEC production and expanding shale oil production to coexist and to increase in lockstep. In the interim, and just as with option number one, revenues would suffer.

There we are. It is a difficult choice between cutting production to keep prices up while continuing to lose revenues because of a loss in market share; and not cutting production and accepting lower prices and revenues while this is unlikely to be an immediate deterrent against US shale production that is flexible and able to adapt to various price levels: prices will have to stay low to contain shale growth -- if they go back up, shale production will increase again. And it is a choice with a huge element of uncertainty because no one really knows how price sensitive US production will prove to be.

What would you do?




Christof Rühl - Global Head:Research Abu Dhabi Investment Authority / Linkedin / 11 26 2014

ISSUES....11/28/2014 - Send Us Your Issues

ISSUES.... Inside, confidential and off the record

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