Cheap Oil at its Third Anniversary

Less than six months after their November 2016 agreement to raise the price of crude oil to 58 dollars a barrel, the Organization of the Petroleum Exporting Countries (OPEC) members realised that supply still exceeded demand. In a single week, at the beginning of March 2017, this bitter truth came home with a vengeance: prices dropped by 8% and the two main oil indices, West Texas Intermediate (WTI) and Brent fell below $50 a barrel, before rising slightly in early April. Next meeting in May . . .


Kuwait was the first to react publicly, proposing to extend for another six months that November 2016 agreement whereby, starting on 1st January 2017, production would be decreased by 1.8 million barrels a day, a drop to be divided among the OPEC members and the Russia-Kazakhstan-Turkmenistan alliance. On the heels of this announcement, the new Saudi Arabian minister of energy, Khalid Al-Faleh reminded the world that his country had no intention of limiting its production to make up for some other countries’ failure to do so. A warning aimed at Vladimir Putin who is taking forever to apply the production decrease he promised in the name of Russia last year: for the moment, the process is said to be only 37% complete. The other governments involved are keeping silent, waiting for the big producers to agree.

Three factors are threatening the agreement to which OPEC has committed its members, not to mention a new decrease of 800 000 barrels a month as of 1st July 2017, meant to be discussed next May in Vienna: the lack of discipline within OPEC itself, Russian ambiguities and US aggressiveness.

OPEC : everyone for themselves

Traditionally, OPEC members comply half-heartedly at best with the agreements reached in their name by their organisation. OPEC is not a private cartel like the Seven Sisters1 until the 1973 oil crisis, but an intergovernmental organisation where political considerations play a role.

Both Nigeria, in spite of the insurgency in the Niger delta, and Libya, despite the oil terminal battle between Marshall Khalifa Haftar’s troops and militias in the pay of Tripoli, have increased their production significantly. At the same time, Iran and Iraq have kept their high prices and broadened their market outlets, notably in Western Europe where they offer a 3% discount on the price of Iranian crude. All of this to the detriment of Saudi Arabia who has lost its outlets both east and west of Suez (– 800 000 barrels a day since October 2016). In June 2014, Al-Faleh’s predecessor already rejected any decrease in production, bent as he was on defending the market share of the world’s largest producer and hoping the ensuing price fall would “capsize” its regional rival, Iran, and the US producers of shale oil and gas.

Since then, however, Riyadh has revised its plans and adopted a new strategy, dubbed “Vision 2030,” meant to create jobs for 20 million Saudis and to prepare for a post-petroleum world. This implies huge investments, at least the partial privatisation of the Saudi Arabian Oil Company (Aramco) and to start with, the departure, willing or otherwise, of five million foreign workers. Achieving all of this will take a lot of money and the kingdom cannot afford to wait patiently till its rivals succumb. Reducing production will cost the royal treasury less than the 2014-2016 price collapse. And a return to the production level of June 2016 would not be to the liking of President Trump who recently met with the heir to the throne, Muhammad Bin Salman.

The other members of OPEC, dubbed by the International Monetary Fund (IMF) the “Fragile Five” (Algeria, Iraq, Libya, Nigeria and Venezuela), are too poor to invest in modernisation and have stagnated for years at lower levels, while their domestic consumption has skyrocketed, leaving less surplus for export. At OPEC meetings in Vienna, they generally vote in favour of production cuts . . . by other countries.

Russian Ambiguities And US Aggressiveness

Moscow’s game is not so clear. The promised cutback was based on a very high initial volume: Russia alone produces more than the former Soviet Union and has made no secret of its ambition to supplant Saudi Arabia as the world’s largest producer. Having nearly recovered from the recession due to the 2014 crisis and the Western embargo, the Kremlin can now afford to wait, unlike the Saudis: the Russian budget is based on an assumption of $40 a barrel by 2019, with every dollar over that going into a reserve fund for use in lean times.

In the States, shale-oil producers have done better than hold their own. In fact it was the spectacular rise in US crude reserves at the beginning of March (8.21 million barrels added to the stock of 528.39 billion) instead of the expected drop, which caused prices to fall. Thanks to spectacular productivity gains, especially in Texas and Oklahoma, the oil companies managed to cope with the bad patch in 2014-16 and keep up their production, contrary to Saudi Arabia’s expectations. They were helped by the banks who extended their credit terms and probably by discreet aids from the Federal Reserve and the Treasury. The new President, Donald Trump favours the expansion of this sector in the US and intends to do away with the obstacles put in place by Barack Obama to protect the environment. Certain that even at less than 50 dollars a barrel they can turn a profit, Shell, Chevron, and Exxon - presided over until December 2016 by the new Secretary of State, Rex Tillerson — are about to invest ten billion dollars in shale oil, which until now has mainly been the province of small and medium-sized companies.

More generally the crisis has certainly caused the majors to cut back their international investments, and yet there too productivity efforts have paid off: the time it takes to develop a new deposit is now two years instead of three or four, and costs have been slashed. Total has announced that in two years the average production cost of a barrel has dropped by 44%, from $9 to $5. And important new discoveries have been made in Alaska and the eastern Mediterranean basin.

An Unlikely Oil Counter-Shock

The International Energy Agency (IAE) an “anti-OPEC” of consumer countries set up by Kissinger in 1973, has predicted another oil counter-shock by the beginning of the next decade after a long tunnel with prices fluctuating between 50 and 60 dollars a barrel. The above facts, however, cast doubt on the validity of this prediction. All the more so as the international demand for crude oil is growing more slowly than before. The world economy is at a virtual standstill. On the eve of the G20 meeting in Baden-Baden, Christine Lagarde, director of the IMF, expressed the hope that it would soon emerge from a convalescence which has been dragging on since 2008. The results of the conference did not incite her to repeat this. China, world’s largest importer of crude oil, has considerably reduced its rate of economic growth. Transportation remains, along with heating, one of the last outlets for crude oil. Yet even there the move towards electric and hybrid cars (100 000 in France alone), despite the oil-companys’ scepticism, will dampen the demand. And in the Northern hemisphere, insulation efforts in private homes will similarly affect fuel oil consumption.

In this rather depressing environment for OPEC members, the only good news comes from speculation. Since March 8th, traders have been trying to take advantage of the difference between spot prices and current futures prices ; the gap over a month (0$.65) is more than the storage cost of a barrel ($0.41) and speculative buying is on the increase.

The Fragile Five have a hard time keeping up

Barring an unforeseen accident, and to the satisfaction, acknowledged or concealed, of the major players in the sector, prices should remain within a corridor of 50 to 60 dollars for the next few years, what with the “price-capping” imposed by US producers now that they can develop their activities, even at depressed prices, and what with the lack of discipline among OPEC countries; not to mention Russia’s new ambitions. But this is not in the interests of oil-producing countries in difficulty, like Nigeria, Libya, Angola or Algeria and of course, the most troubled of them all, Venezuela, with its crumbling economy.

“For the countries hardest hit by the decline in commodity prices, the recent market firming provides some relief, but the adjustment to reestablish macroeconomic stability is urgent. This implies allowing the exchange rate to adjust in countries not relying on an exchange rate peg, tightening monetary policy where needed to tackle increases in inflation, and ensuring that needed fiscal consolidation is as growth-friendly as possible.” This was how the IMF put it in its World Economic Outlook on 17 January 2017. Since that date the “firming” of the oil-market is history and the adjustment to come is going to be even rougher for the Fragile Five.

1Editor’s note: Secret agreement between the major oil companies, concluded in 1928 in order to share oil-production zones, transportation, and distribution via pricing agreements.