The Breakdown of a Cartel: OPEC Powers are offset by U.S. Production

Cenergize Guest Writer / April 7, 2015

A good chess player knows when to sacrifice one of his pawns in order to better his position. In November 2014, OPEC, a cartel made up of an amalgamation of 12 crude producing countries representing 30%-35% of the world’s crude production, faced an oversupplied market of approximately 2 million barrels. In its 166^th meeting in Geneva, OPEC surprised the market by declaring that it will maintain its current production levels at 30 million barrels per day (“bbl/d”). This declaration not only caused oil prices to tumble by more than 50%, it also resulted in OPEC members foregoing billions of dollars in revenues. While OPEC stated that this decision was intended to defend its market share, this action may simply have hastened the inevitable outcome of lower oil prices due to the emergence of the US as the new marginal crude supplier.
OPEC
Under the leadership of Saudi Arabia, OPEC typically has adopted a unified position, despite conflicting interests among its members mostly due to their country-specific economic and financial flexibility.
Many OPEC members use their oil revenues to finance large social programs and therefore need high oil prices to balance their fiscal budgets. Besides low foreign reserves and/or high debt/GDP levels, some OPEC members may not be able to adjust their fiscal budgets to a low oil price environment for fear of social unrest.   As a result, countries such as Venezuela, Ecuador and Nigeria are incentivized to continue to produce crude even at lower crude prices.
In contrast, Saudi Arabia currently holds $738 billion in foreign reserves, or 19 times its estimated 2015 budget deficit. The required oil price to balance the 2015 fiscal budget[1] of oil producing countries along with their foreign currency reserves[2] and debt/GDP ratio[3] reveals that Saudi Arabia has financial flexibility that other OPEC members may not have.

Source: World Bank, Wall Street Journal, IMF

As the largest crude producer in OPEC with ~9.6 million bbls/d produced in 2013[4], coupled with financial flexibility, Saudi Arabia has naturally taken the role of the “swing producer”, and in the past it adjusted its production levels in order to control prices.   This was exemplified in 2009 when OPEC decided to cut its production by 2.5 million bbls/d in order to stem the collapse of oil prices due to decreased demand. Saudi Arabia cut its production by ~1.1 million barrels while the second biggest production decrease came from UAE with 0.3 million bbls/day, followed by Kuwait with 0.29 million bbls/day[5].
Russia
As the world’s third largest oil producer, Russia accounts for approximately 9% of the daily crude production. Despite having relatively high foreign reserves, Russia lacks financial flexibility and is unlikely to collude with OPEC to help raise crude prices due to its dependence on the oil and gas industry which makes up 16% of GDP[6] and contributes to 52% of the federal budget[7]. Russia’s economy is further hurt by the economic sanctions from the west. Russia’s 2015 budget deficit is expected to be ~3.8%[8] of its GDP, or ~4.4x of its reserves. In the past few months, the country has had to use its reserves to prop up its currency as well as local companies, such as Rosneft who received $10.8 billion, VTB Bank with a $1.7 billion injection and Gazprombank who received $680 million. Due to the financial difficulties it faces, Russia is likely to continue to produce as much oil as it can thereby ensuring a current supply glut.   In fact, in January 2015, Deputy Prime Minister Arkady Dvorkovich stated that beyond a “natural decline in oil output by around 1 million barrels per day” there were “no plans to cut production in coordination with OPEC”.[9]
United States
U.S. oil production has skyrocketed over the past several years, increasing from ~5.1 million bbls/d in 2005 to ~8.6 million bbls/d[10] in 2014 (with a run rate of 9.2 million bbls/d by December 2014), representing a 68% overall production increase.

Source: IEA

This increase is mostly due to technological advances that allowed drilling in shale formation, previously thought of as uneconomical areas, and horizontal drilling, which allowed for more efficient production and recovery. These technological advances coincided with an overall U.S. crude price increase which further encouraged investments; monthly WTI averaged ~$50/bbl in 2005 and increased to an average of ~$90/bbl from 2011 to 2014[11].

Source: IEA

Despite the recent sharp decline in oil prices, U.S. crude production continues to increase in 2015, albeit at a slower pace; EIA projects that U.S. production will increase by 600,000 bbls/d, or 8% in 2015, down from a 16% increase in 2014[12].
The increase in production in the U.S. is due to continued flow production from operating wells who are only incurring marginal costs of production and wells that are close to completion, only requiring small additional investments to reach completion. Every geography and specific well has its own economics, however, large commercial companies incur marginal costs in the high teens per barrel while more expensive stripper wells, or old wells with low production nearing the end of their economic life, can have marginal costs of up to $40/bbl; as a result we expect most operating wells to continue producing. While breakeven prices for shale formations reached an average of $70/bbl to $65/bbl in 2014, future drilling will take place in the most economic areas, driving breakeven costs further down and contributing to increased production. As the past has shown, additional reduction in US production costs will likely be derived from pressure on oil field services firms and contractors to reduce their fees.
The US production boom is characterized by a large number of small independent players. Since these producers are nimble, uncoordinated and flexible in their spending, they can quickly respond to price changes. Like many other small to midsize independent American producers, Triangle Petroleum, recently announced delays of well completions until May or possibly longer in expectance of a better price environment. Consequently, the recent sharp oil price decrease has translated in a reduction of the oil rig counts, which has come down from a peak of 1,600 in 2014 to 802 at the end of March. However, as swiftly as these producers adjusted to a $45/barrel environment, they may also react to a new price surge: a new swing producer has emerged.

Source: Business Insider, data via Baker Hughes

A new Producer Landscape
In November 2014, Saudi Arabia and OPEC realized that a fundamental shift in the producer landscape has taken place. With the US shale boom, a new “marginal” producer has emerged, driven by the ability of independent producers to rapidly adjust to market changes. Understanding that a decrease in OPEC’s production will only prop up crude prices in the short run but cede market share to other crude producers who will continue to pump more oil, the Saudis insisted that other producing nations, including Russia and Mexico, also cut their supply; when negotiations failed, Saudi Arabia, together with OPEC, announced that they’re keeping their supply at the same levels[13].
Today, Saudi Arabia is still able to make a profit at lower crude prices, causing pain to higher cost US shale producers. However, low prices will eventually trigger demand, providing a new impulse for US drilling activity as commented by a Gulf delegate in March[14]. Even if Saudi Arabia’s oil minister denies a “price war on US shale” and a decreasing “relevance” of OPEC, the organization will require new strategies and partnerships to live up to this challenge[15].
In short, U.S. oil companies have replaced Saudi Arabia as the “marginal” producers; even if there is temporary uptick in crude prices due to higher demand or reduced supply, the ability of U.S. crude producers to react quickly will ensure that the market stays sufficiently supplied for a while. Saudi Arabia and OPEC may have sacrificed a pawn in order to temporarily better their position, but their options have become limited as the game has changed against the powers of the cartel.
[1] Source: Wall Street Journal. Russia’s statistic is quoted from the Moscow time.
[2] Source: World Bank http://data.worldbank.org/indicator/FI.RES.TOTL.CD
[3] Source: IMF Government net & gross debt 2013
[4] Source : OPEC monthly report http://www.opec.org/opec_web/static_files_project/media/downloads/publications/MOMR_February_2015.pdf
[5] Source: OPEC’s 2009 annual report. http://www.opec.org/opec_web/static_files_project/media/downloads/publications/AR2009.pdf
[6] Source: World Bank Development Indicators: http://wdi.worldbank.org/table/3.15
[7] Source: EIA http://www.eia.gov/countries/cab.cfm?fips=RS
[8] Wall Street Journal: “Russia’s Budget Deficit More Than Doubles in a Month”. March 12^th 2015.
[9]Source Rigzone: http://www.rigzone.com/news/oil_gas/a/136869/Deputy_PM_Russia_May_See_Oil_Output_Fall_by_1M_BPD_at_Most#sthash.lnGv6mB3.dpuf
[10] Source EIA: http://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=MCRFPUS2&f=M
[11] EIA: http://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=pet&s=rwtc&f=m
[12] http://www.eia.gov/forecasts/steo/report/us_oil.cfm
[13] Source: Wall Street Journal “Why Saudis Decided Not to Prop Up Oil”. Dec 21 2014.
[14] Source: Rigzone http://www.rigzone.com/news/oil_gas/a/137819/Gulf_OPEC_Delegate_Global_Demand_To_Help_Oil_Prices_Despite_US_Glut#
[15] Source: Wall Street Journal http://www.wsj.com/articles/saudi-oil-minister-denies-price-war-with-u-s-shale-1425479624

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Written by “SB” who received his masters degree in Economics and Energy policy from Columbia.  SB has been in the natural resources industry in various roles for 12 years and currently works as a vice president in structuring secured loans to commodity companies. SB has accepted to share his opinion and to feed the debate on major energy issues as a Cenergize Guest Writer. SB’s article does not represent the opinion of his employer and does not provide any trading advice nor is it responsible for any.
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