The global oil market is in upheaval. Prices plunged more than 50 percent between mid-2014 and mid-2015, leaving them hovering around $60 per barrel. Consumers, producers, and governments, all having grown accustomed to $100 oil, were taken by surprise. After all, just prior to their collapse, oil prices had held remarkably steady for three years, their most stable period since the end of the Bretton Woods era in the early 1970s.
What only a handful of observers saw coming was in effect a perfect storm: a sharp increase in supply driven by the production of unconventional oil from deep rock formations in the United States, coupled with sluggish demand in Asia’s emerging economic power centers, all intensified by financial speculation.As a result, by the autumn of 2014, markets began to be flooded with oil and prices started to show weakness. At the November 27, 2014, meeting of the Organization of the Petroleum Exporting Countries (OPEC), which drew more attention than any of its gatherings since the global financial crisis of 2008, the cartel was widely expected to cut production in an effort to arrest the price decline.
And yet OPEC did no such thing. Instead, as it left production levels unchanged and prices fell further, observers were quick to declare that the cartel was over a barrel.
In fact, while the fate of individual member states may vary, OPEC as an institution—and Saudi Arabia, its leader—is likely to emerge from this paradigm shift stronger than before in many ways. With its new strategy—one born out of necessity—the kingdom is emphasizing market share, rather than price, while also moving to delegate the burden of balancing the world oil market to the U.S. shale industry. This, over time, will help the kingdom to meet rising domestic demand, and, at the same time, help OPEC lay claim to a bigger share of world oil markets that can be allocated—politics permitting—among resurgent producers such as Iran, Iraq, and Libya in the years ahead. Taken together, the moves mark a significant change in the geoeconomics of oil.
OPEC’s Long-Term View
To be sure, $60 oil hurts OPEC member states. Venezuela would like to see prices shoot beyond the $100 per barrel mark again and lift state budgets out of the red, as would Kuwait and Iran. But looking at the short-term fiscal interests of OPEC members misses the point. OPEC has a long-term view, and it has learned from history—more precisely from the aftermath of the oil price surge of the 1970s.
Embargoes and high prices in the early 1970s brought new producers to the stage, notably Mexico, Norway, the United Kingdom, the U.S. state of Alaska, and the Soviet Union, rapidly expanding global supply by the end of the decade. In response, OPEC started cutting production, which led to a significant loss of market share but did little to stabilize prices, as non-OPEC producers kept on pumping even more. It was Saudi Arabia, the swing producer, that absorbed these losses, while most fellow OPEC countries were free riders.
Saudi Arabia’s oil output contracted to 2.4 million barrels per day (mbd) in August 1985, down from more than 10 mbd in 1980. In 1986, when the kingdom eventually opened the floodgates and ramped up production to 5 mbd, prices immediately collapsed, falling 50 percent from 1985 to 1986.
This undoubtedly hurt OPEC economies. In Saudi Arabia, which had cut production from 1982 onward, the state budget was already in deficit when the price collapsed.
Yet the long-term effect of the low price was a declining market share for non-OPEC producers in the United States and Northern Europe, whose higher production costs were no longer sustainable in the new price environment. OPEC learned an important lesson: accept the immediate pain and come out stronger in the long run.
Today, Saudi Arabia’s economy is far better prepared for a sustained period of low oil prices than ever before. In the mid-1980s, the ratio of Saudi Arabia’s gross domestic savings to gross domestic product (GDP) was about 10 percent; by contrast, 2013 figures from the World Bank suggest a savings rate of 44 percent. The country has one of the lowest debt-to-GDP ratios in the world, even as social spending has accelerated in the wake of King Salman’s ascension to the throne in January 2015, draining foreign reserves by $36 billion, or 5 percent, in only two months.
As Riyadh imposes its will on OPEC, it is prepared to accept short-term budgetary pressures in order to salvage market share in the most important commodities market in the world. That its rivals Russia and Iran are also losing out due to the low price is simply icing on the cake.
High-Cost Competitors Feel the Pain
Low oil prices hurt producers that need prices consistently above $60 a barrel in order to be profitable. That means the biggest loser in the current market is not OPEC, but high-cost producers such as Brazilian offshore ventures, Canadian oil sands, many Russian greenfield projects, which require the construction of new facilities, and, in specific areas, the U.S. shale industry.
Already, prices below the $50 mark have put international oil majors into rationalization mode. BP announced a $1 billion restructuring program in late 2014 that called for thousands of jobs to be eliminated by the end of 2015. ConocoPhilips followed suit, while Schlumberger, the world’s largest oil services company, said in 2015 that it would lay off 15 percent of its workforce. Oil stocks saw a bloodbath, and, in mid-2015, U.S. rig counts were at their lowest levels since mid-2010.
Canadian oil sands in the province of Alberta have high up-front costs but far lower operational costs than conventional oil, meaning that projects that are already on line or under construction will continue apace, but a broad swath of future investments will be scrapped if low prices persist—casting doubt on the prospects of a resource base that was at one point expected to shoulder the lion’s share of future non-OPEC supply growth.
The up-front investment required to extract shale oil is comparatively low, making it easier to halt production when spot and short-term futures prices are low, and to begin drilling again when prices pick up.
In the near term, many of the small and midsize players that dominate North America’s shale sector will not survive. They lack the deep pockets and diversified risk portfolio of the oil majors and their state-owned OPEC counterparts and will increasingly be forced to consolidate and restructure.
The impacts are already being felt across the U.S. states of Texas and North Dakota. Many companies that are active in shale oil have been spending more than they are taking in, and they have relied on optimistic price and productivity assumptions to fund their growth. Their debt has overwhelmingly been downgraded to junk status; their revolving credit facilities, linked to the price of oil, are shrinking; and capital is increasingly scarce.
OPEC Goes for Market Share
For most of its existence, OPEC has been haunted by the classic collective action problem facing all cartels—the difficulty of getting all players to restrain their own output and buoy global prices when each in isolation faces an incentive to maximize production. In 1982, the organization initiated production quotas for individual member states in order to support targeted price levels. However, OPEC members had obvious incentives to disregard their own quotas, leaving production cut decisions to other members—and allowing the free riders to reap the benefits of higher prices.
Since 2008, the organization has only had a target for total production, without individual quotas, making the collective action problem even more severe. This situation was mitigated—though not fully resolved—at OPEC’s November 2014 meeting, when Saudi Arabia pushed the cartel to defend its portion of the global market, at the expense of letting prices fall even further.
This strategy makes intuitive sense. It transfers the burden of adjustment onto other producers, both within OPEC and outside of it, including countries that in the past took advantage of Saudi Arabia’s willingness to manage the oil market by increasing or decreasing its exports. And it is beginning to force non-OPEC production to shrink as relatively expensive conventional and unconventional oil projects become uneconomic.
It also puts pressure on other OPEC nations, including many with inflated state budgets that can only be supported with higher oil prices. These producers face the tough choice between increasing exports and pushing prices even lower, or decreasing exports to help balance the market, allowing Saudi Arabia to quickly assume their market share. After forcing consolidation among these fringe players, the kingdom will be better able to exert market power in the future.
While Saudi Arabia could tolerate, albeit reluctantly, greater production from smaller OPEC states, it is far more concerned about increased exports from Iran, should international sanctions on the country be lifted as part of a long-term deal on its nuclear program. It is conceivable that the combined production of Iran and Iraq—which is also trying to rebuild its oil industry after a long period of war and other disruptions—could exceed that of Saudi Arabia within a matter of years.
The Saudi Challenge
As the strongest player in the world oil market, Saudi Arabia has always sought to keep prices above a lower bound that would discourage a healthy degree of investment and competition among suppliers and below an upper bound that would begin to erode long-term oil demand. Recent oil market dynamics, however, have challenged both the strategic rationale and practical feasibility of this approach.
The 1.5 million barrels per day of additional U.S. oil produced since mid-2013 is predominantly high-quality light sweet crude, mostly from shale formations. Light sweet crude producers in OPEC—specifically Algeria, Angola, Libya, and Nigeria—also saw increased exports of nearly 1 million barrels per day in 2014, even as Saudi Arabia’s exports fell slightly. The kingdom’s only option, if it wanted to try to address the global glut, would be to reduce exports of its relatively small share of lighter crude production. But this would quickly be matched by an increase in U.S. shale production or other light production in Iran, Iraq, or Libya as those countries seek to return to the market.
An inverse situation in 2011 illustrates the dilemma. In that year, Saudi Arabia raised production of its medium-to-heavy sour crude oil to compensate for light sweet supplies from Libya that had been disrupted by the civil war there, only to find that oil prices continued to shoot upward. Libya’s traditional customers in Europe and elsewhere, boasting refineries well-suited to Libya’s disappearing production, had little use for the Saudi exports.
In today’s oversupplied market, Saudi-led OPEC has largely been forced by structural factors to continue producing. Going forward, if the purge of high-cost producers from the market is less rapid or comprehensive than Riyadh desires, Saudi Arabia has the option of increasing production further, perhaps even eliminating its 1.5 million barrels of flexible spare capacity. There are indications it may be positioning to do so, with Saudi rig counts reaching all-time highs just as U.S. counts decline.
Increasing production further would help Saudi Arabia to offset the revenue hit of lower prices, and it would stabilize these flows further by locking in long-term supply agreements at historic production volumes. Such a move would also dissuade Iran from returning supplies to the market, particularly coveted Asian markets, too quickly, out of fear that prices might collapse even further—a risky scenario for a country with limited capacity to weather such a storm. And it would help offset Saudi Arabia’s growing domestic oil consumption, which threatens to cannibalize the Saudi crude production available for export in the years ahead.
The Shifting Geoeconomics of Oil
OPEC’s November 2014 decision not to impose production cuts was a historic shift in strategy and may in time represent an abandonment of the cartel’s role in stabilizing the market. It was also a calculated, long-term strategic decision by Saudi Arabia and OPEC. The move to let the market do the job of removing oversupply could be reversed at any point with a decision by OPEC to cut production. But a fundamental change in who is responsible for balancing the global oil market—and how that is accomplished—is already under way.
For Saudi Arabia, there are several reasons to give up the role of the market’s swing producer, a powerful economic and political tool that has been unrivaled for many years. Domestic oil consumption in the kingdom is on the rise as Saudis drive more and crude is burned in power stations to satisfy growing demand for electricity. At the same time, the country is adding extensive complex refining capacity through joint ventures as it seeks to climb the petroleum value chain and create more jobs. This growing domestic demand eats into the exportable crude supply and reduces Saudi Arabia’s ability to nimbly adjust export volumes. The country’s partners in the new refineries—including many Western firms—will seek to maximize utilization levels and profits, and will have little appetite for politically motivated swings in the share of crude oil production available for domestic purposes.
For all these reasons, Saudi Arabia must inevitably sacrifice its spare capacity at the altar of a growing, evolving domestic economy.
The shift is forcing the North American shale industry—seated precariously on the edge between profit and loss—to assume the role of marginal producer. And, in some ways, the shale industry is ideally suited to this position, as it can quickly adjust output to market conditions. Unlike the kingdom’s adjustments, however, which emanate from a single decisionmaking apparatus, the shale industry’s adjustments are the result of thousands of disaggregated decisions made by individual oil companies across the United States.
Once oil prices fall below running costs, production at shale wells can quickly be halted, then ramped up again rapidly when prices pass that threshold (or at least when producers see futures prices they view as advantageous). This fast expansion of output theoretically places a soft ceiling on the oil price and helps to ensure that prices don’t overshoot again as long as swings in demand are gradual and do not outstrip the volume of shale reserves that are ready to shift quickly into production. OPEC’s move to transfer the burden of market adjustment on shale, therefore, has the potential to overcome the traditional long cycles of boom and bust that characterized oil markets in the past.
While it is far from certain that the notoriously volatile oil market will become less cyclical, Saudi Arabia would unquestionably welcome such a shift. As Saudi officials and their proxies have said many times, Riyadh welcomes shale oil as a key addition to global production—as long as its own position in the market is unthreatened. It would also welcome the more stable prices—and stable revenues—that would come if shale can truly assume the role of global marginal supply. The question is whether the growing North American petroleum industry, triumphant in its rhetoric of having turned the market on its head, will be pleased with this new position when the dust settles.
A Changing Role for OPEC
What do these shifts mean for OPEC itself? Nigeria’s oil minister, Diezani Alison-Madueke, who was elected president of the cartel in late 2014, said in a February 2015 interview that “Opec’s role needs to be slightly recreated over the next 24 months or so. . . . The face of global crude and global energy is changing and it’s changing very rapidly, if we intend to stay relevant we have to change with it.”
It remains to be seen what shape this will take. Several producers in the Middle East are poised to increase production capacity significantly in the years ahead, likely straining OPEC’s contentious production targets and heightening tensions at future meetings. Other producers, like Venezuela, are beginning to propose novel approaches such as multimember blending strategies to create new crude varieties to help OPEC oil compete with shale oil and oil sands in crucial battleground markets such as the U.S. Gulf Coast.
Although market cooperation among OPEC states has been remarkably resilient to political issues, and even to war between some of the members, it is susceptible to political changes at every level.
The long-term implications of the April 2015 leadership reshuffling at Saudi Aramco, the state-run oil company, and the anticipated retirement of Saudi Arabia’s oil minister of twenty years, Ali al-Naimi, are not yet clear. More broadly, the ascension of the Sudairi clan to power in the kingdom—against the backdrop of a trilateral tango among Iran, Saudi Arabia, and the United States—underscores that the political environment surrounding OPEC’s most consequential decisions has rarely been as opaque.
If it is impossible to predict the duration and denouement of this market transformation, then perhaps there is only one sure thing that can be said: Saudi Arabia is focused, with a discipline that has surprised many, on expanding its market share.
As one of the lowest-cost, most efficient producers in the world, it can continue this strategy for as long as it deems necessary, or at least until other producers, whether in OPEC or not, agree to a coordinated production cut that would help boost prices. Absent such a development, North American shale will compete with other marginal suppliers, thanks largely to continued efficiency improvements and cost reductions that are already having an impact. But over time, even the greatest efficiency improvements for shale are unlikely to deliver break-even prices as low as those of OPEC producers such as Iran, Iraq, and Libya, which could all regain their footing in the global market in the years to come.
Saudi Arabia’s predominance in the market is not in doubt. But if other players in OPEC open the spigot, the market’s second-most-important actor will be in significant flux. Shale’s technological advances will be pitted against the will of OPEC’s sleeping giants, Iraq and Iran. The outcome is anyone’s guess. From Houston to Tehran to Baghdad and beyond, the world is entering a new era of uncertainty in the geoeconomics of oil.