There is a supply glut in crude oil. Oil prices have been in freefall, and yet, OPEC doesn’t seem to be bothered about cutting down production. It doesn’t take a genius to realize there is something wrong with the market. The supply side has been leaping ahead of the demand for quite some time now. This is not an industry where you can change things with the flick of a switch; it’s always difficult to stop billions of dollars moving in a certain direction. However, it has been 18 months since the time oil prices started falling (more or less consistently with minor recoveries). From more than $100/barrel the prices have now fallen to under $40/barrel.
Is OPEC responsible for all this? Is this how a true market economy behaves or is this still an OPEC economy?
OPEC Is Not the Cartel You Think It Is
Many of us have grown up imagining OPEC to be this big cartel that moves the market where it wants. While some of that is true, the reality is far from what most people imagine. A cartel by definition acts like one big producer and tries to fix prices, production and its profitability. Let’s see how much of that fits OPEC.
1. OPEC Doesn’t Control Everything:
OPEC controls about 40% of production today. That’s quite a lot, so it does have influence. However, it can’t dictate everything to the market. OPEC can control its own production but it can’t control what 60% of producers will do or how demand will catch up with supply. For example, the U.S. is expected to make heavy cuts to production by the end of 2016.
2. Member Countries Don’t Agree With Each Other:
Rich countries like Saudi Arabia, Kuwait, Qatar and the UAE may not mind low prices, but poor countries like Nigeria, Angola, Venezuela and Algeria do. Saudi Arabia and Iran have had strong political differences and continue to fight a proxy war in Yemen. Iran is eager to grow its production by up to 1 million barrels per day as their sanctions are lifted. Iran’s growing influence is considered a threat by Iraq and Saudi Arabia. Many such deep and historical differences (and motivations) result in speculation and price volatility. So OPEC can’t be considered one big producer.
3. It Gives Away Profits:
Last Friday, OPEC threw profitability out the window when it gave a free hand to its members to produce as much as they wish (you might have heard “no ceiling” in the news). This means they will continue to sacrifice profitability in order to gain market share.
It is probably more appropriate to refer to OPEC as an organization that has influence over the market rather than as a cartel. It will help us understand their behavior better.
Is OPEC Dead?
Look at what has happened to oil prices in the last 18 months and then check how many members have returned their membership cards. You will get the answer. In fact, Indonesia is re-joining OPEC next year. Clearly, despite their differences, members find they are better off being part of the organization. So “OPEC the organization” is not dead, but what kind of influence does it really have? These points may answer that:
More than 70% of oil reserves left to be extracted are controlled by OPEC member countries. That’s huge and will not change. But how important these reserves will be in 2025 (given renewables are now in the equation) is a different topic altogether.
2. OPEC Can Take Irrational Risk:
The supply glut phase from mid-2014 has been about market share. OPEC countries have gladly sacrificed not only short-term profits but have also put themselves in considerable risk in terms of balancing their budgets. Why are they able to do all that? Take a look at the most important OPEC countries – Saudi Arabia, Kuwait, UAE and Qatar – all are monarchies with effective leaders. They can and do take risks that a normal democracy would not be able to. Libya, Iraq and Nigeria have too many problems of their own to exert any influence, while Algeria, Indonesia and Venezuela are not powerful enough to challenge things. So even though OPEC members might not agree with each other, they follow what the rich, monarchist countries want to do. Below is a chart of what the oil prices should be if member countries want to balance their budgets.
At current price levels almost all countries are running losses and taking abnormal risks. Democratic countries like the U.S., Canada, Russia, China and Mexico can’t keep taking such risks. Not to mention that most of these economies are barely moving along at this stage.
Take a look at the graph below. Overall non-OPEC production has been decreasing since 2014 and will continue to do so in the near future (while OPEC countries are either holding on to their production levels or planning to expand).
So is OPEC powerful? Yes! OPEC has flooded the market with oil and put their own budgets at risk. They are putting the shale producers and traditional oil producers under pressure to back out of this price war. Maybe they are leading themselves and the global oil industry into a catastrophe, but they are doing it because they can. If that isn’t power, what is?
The Bottom Line
OPEC might be a fractured group but it is led by countries who can take an abnormal amount of risk. This is not the first time that they have made shocking changes to oil prices just because they wanted to. Being powerful, however, doesn’t mean you always win. It only means you get to do what you want. Member countries will put their credit rating and debt situation into severe pressure in the coming year.
Saudi Arabia, the biggest and most important OPEC member, might be asset rich but it is cash poor. In fact, the biggest beneficiaries in all this could be Qatar and the UAE. Their budgets are not really at risk even if oil stays range-bound below $50-$60 in the next five years.
Next year will be a crucial deciding year. We might see OPEC coming out strong or we might see the organization fail miserably in front of the market economy. Don’t be so happy about that. It might not be pretty. In the meantime, you might want to find good investment opportunities in Qatar and the UAE. You can thank me on twitter if it works out.
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