OPEC Inaction Analysis – Supply – 5/16/16

Recently, oil markets seem to bend more to one-off disasters than OPEC maneuvering. The latest example comes in the form of wildfires that knocked about 1 million barrels of daily production offline near Alberta, Canada, which quickly overshadowed the ouster of longtime Saudi oil minister Ali al-Naimi. A similar indifference to OPEC policy shocks can be seen in the comparison of the last minute collapse of the Doha freeze deal to the Kuwaiti oil worker strikes and terrorist-related pipeline disruptions in Nigerian and Iraq.

Why has OPEC managed to do so little to drive oil prices back up?Sure, some members like Venezuela desperately called for meetings and production cuts, but its largest producers appear content to ride the low prices out. The devastation done to oil revenues has forced many countries to cut subsidies, increase taxes, and undergo significant political unrest giving them ample incentive to act, so what has made the group’s efforts so lackluster?

The de facto leader of OPEC, Saudi Arabia has been especially uncompromising when it comes to its wait-and-see policy. Yet, its strategy of faux-action and “maintaining market share” is backed up by sound logic if the goal of Saudi leadership is to maintain long-term control of their nation even if it means short-term suffering for citizens and allies.

Oil prices crashed because the oil supply outgrew oil demand. Explosive growth in production from the U.S. frackers was already leading to an oil glut in the top consumer nation even before demand from emerging markets tanked.

US total production

well age

As shown in the EIA graphs, a spike in crude oil and natural gas production from 2012 to 2015 coincides with the plummeting average age of U.S. oil wells. Advances in fracking technology were the cause. New drillers looking to take advantage of triple digit oil prices easily hurdled low barriers to entry. Capital costs and start up times for shale-oil wells were fractions of what was necessary for traditional wells leading to the proliferation of young wells. Even as prices fell, frackers were able to increase their efficiency leaving the technology ripe for a come back at prices as low as $50 a barrel.

A major driver of Saudi inaction on freeze deals and output cuts is its stated desire to drive higher-cost producers like shale drillers out of oil markets. Such a desire is understandable given that cuts to output that OPEC had historically used to keep prices high would essentially subsidize the very producers eating into their market share. The strategy has been successful given the number of bankruptcies coming from the U.S., but the damage comes far later than most analysts expected, and now stockpiles are bulging, hundreds of wells are pre-drilled, and fracking is more efficient than ever.

It’s little wonder Saudi policy makers are preparing for an oil-independent future when their competition grows so much faster than their customer base.

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