For several decades the Organization of the Petroleum Exporting Countries (OPEC) has had a major impact on global oil prices. In its “good old days”, the cartel used black gold as a leverage to achieve its geopolitical goals. Nowadays, as prices continue to drop and competition multiplies, many doubt OPEC’s ability to further control prices and ensure market stability, and openly question its very existence.

After the last OPEC Vienna meeting in late November 2014, when cartel has decided not to cut its production of 30 million barrels a day, analysts and media worldwide had concluded that OPEC’s dominance has evidently eroded. Francisco Blanch, the Bank of America’s  commodity chief, said OPEC is “effectively dissolved” after it failed to stabilize prices at its last meeting, and free market now controls the global cost of oil. The “consequences are profound and long-lasting” he added.  Is he right? Does OPEC really have no meaningful influence left and are we about to witness a major shift in global energy market powers

Divided opinions

“The conclusion that OPEC is dead is rather simplistic,” said Dr Carole Nakhle, Energy Economist Expert and Director of UK based Crystol Energy Ltd.  “If OPEC has not announced any production cuts yet, this does not necessarily mean that the OPEC era is over. Of course, in economic theory cartels don’t last forever and today market conditions have changed fundamentally hence the coming years are going to be challenging for OPEC.” According to her it seems that the organization is currently taking some time to think about its next strategic move under these new conditions. 

Roger Guiu, from the Middle East Research Institute, is even more convinced that OPEC still holds much power in its hands: “OPEC’s potential to influence the oil price remains intact. The OPEC is still an extremely powerful cartel that could drive prices up again if eventually they agree to decrease their aggregate production,” he tells bq.

But for Guy Caruso, a senior adviser from the Energy and National Security Program at Center for Strategic and International studies (CSIS) , it is evident that OPEC’s importance is fading and that OPEC is about to witness significant changes. “OPEC’s role as a “cartel” has been ineffective for many years. OPEC has been dependent on one dominant member-Saudi Arabia-for many years because Saudi Arabia is the only member with meaningful excess production capacity. This situation is likely to remain true for the foreseeable future,” he states.

OPEC’s primary goal, since its formal creation in 1960, has been the support of price stability. But as recent events show, OPEC’s role as the controller of crude oil pricing is coming to an end. From 2010 until mid-2014, world oil prices had been fairly stable, standing at around USD 110 a barrel. But since June prices have more than halved. Variety of factors such as supply glut, lower demand and stronger US dollar have all contributed to falling oil prices.

For years OPEC has controlled oil prices by increasing or cutting production, but this time, many experts believe, the cartel will not be able to compete with rival producers and many predict some of the largest producers could see major change and shift from governmental control to market driven prices. For Guiu such a conclusion is premature: “I would be cautious to say that politics in the oil sector is dead and now it is the free market that rules. And, in some way, the decision to maintain production quotas is in itself a political decision that pushes the oil price downwards.”

What has happened?

OPEC’s primary goal, since its formal creation in 1960, has been the support of price stability. But as recent events show, OPEC’s role as the controller of crude oil pricing is coming to an end. From 2010 until mid-2014, world oil prices had been fairly stable, standing at around USD 110 a barrel. But since June prices have more than halved. Variety of factors such as supply glut, lower demand and stronger US dollar have all contributed to falling oil prices.

For years OPEC has controlled oil prices by increasing or cutting production, but this time, many expert believe, the cartel will not be able to compete with rival producers and many predict that some of the largest producers could see major change and shift from governmental control to market driven prices. But for Guiu such a conclusion is premature: “I would be cautious to say that politics in the oil sector is dead and now it is the free market who rules. And, in soCrude oilme way, the decision to maintain production quotas is in itself a political decision that pushes the oil price downwards.”

US and Canada’s increased production have certainly contributed to oil price crumble, as their ever larger domestic production of light tight oil through “fracking” has led to plethora of oil supply.US domestic production has nearly doubled over last six years, while Saudi and African oil that were once exported to America, begun to compete for Asian markets and were forced to play increasingly by free market rules, lowering their prices in order to get market share.

 

Saudi Arabia – the key player

Saudi Arabia’s shift in its primary market is possibly the most important change that occurred. And kingdom’s refusal to cut its production in order to stabilize global prices is seriously undermining OPEC’s role of price. Saudi Arabia possess more than 16% of the world’s proved oil reserves but the most important factor of Saudi influence, according to the strategic advisor on energy policy Elias Hinckley, stems from the fact that Saudi crude oil is stunningly inexpensive to produce compared to the current global market.

David Livingstone, an associate in Carnegie’s Energy and Climate Program, explains: “The Saudis believe that they are amongst the most efficient, low-cost oil producers in the world. The production cost of Saudi oil is at least USD 50 to USD 70 less than that for U.S. shale or Canadian oil sands.” Thus, it would make little sense for Saudi Arabia to voluntarily surrender market share to oil production that is more expensive and, in many cases, more environmentally harmful.

“From the Saudi perspective, it is not they that are the “aggressors” in any oil market skirmish but instead new supplies of North American oil, which have steadily crept upwards even as Saudi oil exports declined slightly,“ Livingston said. According to him, many, perhaps naively, expected OPEC to yield to the emerging supply and demand imbalance in oil markets by cutting its production quota. But OPEC, strongly influenced by Saudis, did not cut production, and markets and analysts subsequently found themselves racing to declare the beginning of a “new normal” of low prices and market share competition in the oil sector.

Conspiracy theories

In the last several months, many different theories related to this issue have surfaced, making the headlines all over the globe. Many have presumed that OPEC, notably Saudis, wants to eliminate the weaker producers by bringing down the prices, which would be still high enough to assure profits for KSA. At the same time Saudis would squeeze U. S shale producers, who need high global price to keep their projects sustainable. After achieving this, the prices will climb again, leaving the Saudis even larger share of the market.

Many so believe that oil price downfall is a part of a larger geostrategic game. The Iranian oil minister, for example, is convinced that there is a “political agenda” behind current drop in oil prices. Many believe that Saudi strategy is to put pressure on the economies of energy-dependent Russia and Iran, which will suffer greatly from current price slump.

In an interview for Teheran Times, Chris Cook, a Senior Research Fellow at the Institute for Security and Resilience Studies at University College London, supported some of this suspicions by saying that” U.S. and Saudis agreed that oil prices should rise to levels with which Saudi Arabia was comfortable.. U.S. did not care about higher oil prices, because they are able to simply print dollars to pay for it.”

Cook added that “The U.S. needed an oil price sufficiently high as to mobilize the necessary massive investment in shale oil, and neighboring Canadian tar sands and that is what a U.S. understanding or agreement with Saudi Arabia delivered.”  The high prices which continued from 2009 to 2014 were supported by a combination of investor capital and liquidity from the U.S. Federal Reserve Bank’s ‘Quantitative Easing’ dollar printing.”

And it didn’t hurt that Russia paid instant price for the price drop. Its economy had been already struggling with currency depreciation and Western sanctions over Ukraine, while collapsing oil export revenues pushed Russia in even more desperate situation.  Just recently, country’s sovereign debt has been downgraded to “junk” status for the first time in a decade by ratings agency Standard & Poor.

OPEC4
The longer that low oil prices persist, the more difficult life becomes for the least competitive and most isolated petrostates, including Russia, Venezuela and Iran.

Are these just coincidences or is there some truth in these speculations? For Dr. Nakhle, any political plots and conspiracies do not have valid foundations: “By properly studying the developments in the oil market since 2011, one can clearly see the power the market fundamentals – namely global demand and global supply, which do not give any support to those conspiracy theories”.

Caruso further explains that Saudi policy is commercially driven and Saudi Arabia had very little choice because they could not expect any assistance from OPEC members or non-OPEC members to lower oil exports and put pressure on prices themselves. The Saudis were unwilling and unable to shoulder the market balancing role on their own. They have the financial ability to ride out this down cycle in the market for several years.

The fact that lower oil prices slow down investment in high cost upstream projects, provides an added benefit.  If low prices hurt Iran, Iraq, Syria and Russia that does not displease Saudi Arabia but that is not their primary objective,” Caruso is convinced.

Guiu agrees: “There are other cost-effective strategies that the Gulf nations can choose to hurt Iran or Russia. This would be a rather expensive foreign policy because the Gulf nations are also hurt by low oil prices”.

A break-up in 2015?

Recent events are also one of the toughest tests of OPEC’s cohesion. Relations between some member states have been all but smooth, with some of them literally in war with each other, but this heterogeneous group of countries managed to stay together over the years. This time, Iran, Venezuela and Algeria have been pressing the cartel to cut production and stabilize oil prices, but Saudi Arabia, the United Arab Emirates and other gulf allies are refusing to do so.

“These entreaties have fallen on deaf ears, as the Saudis have made clear that they do not wish to yield market share to new players, including North American shale and oil sands production, if this action would not even guarantee prices stabilizing at a high level,” explains Livingston.

But such a stance may have immense consequences for the very existence of the OPEC. Guiu expressed serious concern by saying that he strongly sees OPEC under deep internal clashes that could lead the cartel to break-up this 2015. “This forecast is based on the drastic structural differences that OPEC’s economies show. There are some countries, led by the Gulf nations that are able to resist a period of low oil prices due to strong fiscal fundamentals and a large financial power.” 

Alongside with Saudi Arabia, UAE, Kuwait and Qatar have also amassed considerable foreign currency reserves, meaning that they could run deficits for several years if necessary. Furthermore, in the last decade GCC states have tried hard to diversify their economies, and some of them, notably UAE, have been very successful in doing so.

But most importantly, Gulf states posses a huge “piggy bank” in the sense of their Sovereign Wealth Funds, created exactly for overcoming such situation on unpredictable oil market, holding around USD 2.5 trillion. However, Livingston adds that such a strong showing by the Saudis has not gone without criticism, including those coming from the GCC, when recently the oil minister of Oman criticized the decision as short-sighted.

“I would argue that a significant demand cut by OPEC at the end of 2014 would instead have been the short-sighted move, but we can expect this criticism to endure, and even to intensify, as the most vulnerable OPEC producers come under severe budgetary strain over the course of 2015,” said Livingston. However, there are other instruments for stabilizing the budgets, like cuttinge public spending, notably civil service salaries and fuel subsidies.

Other OPEC members such as Iran, Iraq and Nigeria, with greater domestic budgetary demands because of their large population sizes, are expected to face much greater difficulties including political and public unrest as they will not be able to balance their budgets next year if Brent crude stays at today’s price.

Venezuela’s PetroCaribe program, for example, is already showing cracks with renegotiations of debt arrangements taking place with neighboring states, while New York times reported that because the country is so dependent on oil sales to buy imports of food, medicine and many other basics, the drop in oil prices means that there is even less hard currency to buy what the country needs.

“The longer that low oil prices persist, the more difficult life becomes for the least competitive and most isolated petro states, including Venezuela, Russia, and Iran,” warned Livingstone. Even worse scenario may be expected in Nigeria as energy sales account for up to 80% of all government revenue and more than 90% of the country’s exports.

With huge structural economic differences among OPEC members in mind, Guiu emphasized that “the interests of these two groups have become radically different with time (the first group willing to go through a period of low oil prices in order to maintain their market share; the second group willing to cut production and rise prices in order to alleviate their financial situation). Break-up due to lack of unity is a serious possibility!”

Game changer

Current oil market developments are closely linked to the US “shale boom”, which has been seen as major contributor to oil price decline in 2014 (Livingston adds two more factors: disappointing economic data out of China and other key oil demand growth centers in the latter half of 2014, and the end of the U.S. federal reserve’s “QE 3” bond purchasing program that had infused global markets with liquidity and supported elevated asset prices). Over the summer, the US surpassed Russia and Saudi Arabia as the top global oil producer posing a direct challenge to OPEC.

According to Caruso, “US oil production is projected to continue increasing in 2015 and 2016 because of investments made during the last 5-7 years. The US output increase will slow down as capital expenditures are reduced and we could experience a market bottoming out in 2016 and prices beginning to increase somewhat.”

However, some believe that the current low also calls into question the commercial benefits of high cost shale production, which can be three or four times that of extracting Middle Eastern oil. But most analysts share an opinion that North American shale producers can reduce the capital costs for drilling in no time. Peter Zeihan, a geopolitical strategist at Zeihan on Geopolitics firm, told bq that “most challenging US shale wells take less than five weeks of time and USD 20 million each to drill, so whenever the oil markets tighten up just a touch, US shale drillers will be back at it.”

Oil machine
OPEC is still producing around 40% of global oil and its key members, mainly Kuwait, Saudi Arabia and the UAE had the largest share of global oil production in 2013 since the early 80s.

On the other hand, other drilling projects costs billions and take years to reach initial production. Therefore, “many of those projects will not make sense again until after the Americans run out of shale oil completely, and that isn’t likely to be before 2035.”

“Technological breakthroughs have always altered the dynamics of the oil market,” said Dr. Nakhle, pointing out that similar happened with deep-water offshore drilling couple of decades ago.  “Hydraulic fracturing enables those hydrocarbons to flow at sufficient quantities to make large scale investments profitable.

These developments have changed the structure of the industry in North America and could spread to China, Argentina and other regions including the Middle East and North Africa,” Caruso added.  But, on the other hand, high oil and natural gas prices in the past decade have stimulated huge investments and much higher production than expected as recently as 2008, and as the result oil supply has outpaced demand and prices have plummeted 60% in 6 months, Caruso continued.

Therefore, both fracking and clean energy are major market shifts that are here to stay, and OPEC must accept it in order to survive.

“In addition, the lack of unity within the OPEC has also become something structural already rather than temporary. A united OPEC seems the only factor that could drive oil prices up again,” said Guiu.

A glimpse into the future  

A shared opinion is that OPEC will have to face long-term uncertainties and crucial challenges on both, homeland and external fronts. While oil will remain most important energy source, technological progress, introduction of alternative oil sources and transport fuels will slowly but surely reduce the importance of OPEC’s oil.

The decline of the US shale gas industry is still pretty far away, so it is premature to talk about a raise of OPEC’s influence after the industry decline, warns Guiu OPEC states will continue to face competition, especially after shale revolution spreads to other parts of the world. It seems that the Gulf states, most notably Saudi Arabia, realize the new reality is here.

“Saudi leaders have long been fond of noting that ‘the Stone Age did not end for lack of stone’, and they realize that nor will the oil age,” noted Livingston. “This implicit shift in strategy by OPEC, refusing to cut production quotas amid a dramatic change in supply and demand balances, means that the Saudis are backing up their words with action: they will not allow their oil to be pushed out of the market in what may be the beginning of the end of the oil age.”

But although we may see the end of OPEC as we have known it, the association is still very alive. “The structural changes discussed will be with us for the long term. The oil market will eventually stabilize and as current consensus is that prices are likely to settle in USD 70-90/barrel range in the long term” Caruso said.

This may reduce gap between OPEC members and bring them closer together. Livingstone agreed OPEC will not likely break apart any time soon, but its nexus of power will increasingly gravitate away from Vienna, the cartel’s nominal headquarters, and instead toward Riyadh, where the decisions that shake the very foundations of oil markets continue to be made.

“OPEC is nowhere close to dead; but its actions – or rather lack thereof – are certainly pushing the world into a new oil era,“ he concluded.

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