Has OPEC Abandoned the Defense of its Market Share?

After several unsuccessful attempts to reach a supply reduction agreement to shore up oil prices, OPEC agreed in November of last year to cut its daily production volume by 1.2 million barrels per day (mbd) to take effect on January 1, 2017. Six hundred thousand barrels additional reductions were also committed to by non-OPEC producers such as the Russian federation, among others. The market celebrated the agreement by pushing the price of Brent oil from about 45 dollars before the agreement to about 53 dollars afterwards. Historically, this price level is well above the lowest level of 31 dollars it reached in January 2016, but is still less than half its peak level of 112 dollars reached in June 2014, before the onset of the decline (Figure 1).

Considering the relatively moderate effect that the agreement has had on oil prices, on the one hand, and the modest pronounced objectives behind the reductions in supply, as elaborated by the oil minister of a major oil producer, on the other hand, it becomes useful to consider the factors that stood in the way of reaching a similar agreement in the past or contributed to the success of the one at hand.

One of the main factors that prevented an agreement in the past was the intra-OPEC competition for market share as demonstrated repeatedly by the refusal of Iraq and Iran to freeze, let alone reduce their production level. Their justification centered around the forced curtailment of their production levels and capacity growth over a long period due to security and political instability in Iraq and, for Iran, the imposition of international sanctions due to her nuclear weapons program. Iran succeeded under the November Agreement to extract an increase, let alone a reduction or a freeze, in her production level, while Iraq agreed to a modest reduction. What has made it possible for these two countries to come on board is the fact that the reference (1 November, 2016) production levels from which the adjustments need to be made are well above the levels of the recent past. Iran’s production rose from 2.8 mbd in Q4/2015 to 3.7 mbd in Q4/2016; an increase of 0.9 mbd, while Iraq’s production grew from 3.3 mbd in Q3/2014 to 4.6 mbd in Q4/2016, and increase of 1.3 mbd. The fact that Iraq’s production has temporarily plateaued over the last few quarters, while her production at a record historical level must have contributed to the outcome. Similarly, for Iran whose production as of November, 2016 was back to its pre-sanctions level (Figure 2).

The second factor that contributed to the agreement was the resilience demonstrated by the US shale oil industry. For despite the painful consolidations that has been going through and the economic pains endured by some of the host states, the industry over all has withstood its grounds against a first serious test of its strength and resilience. It is noteworthy that US oil production, after falling from a peak of 15.2 mbd in November 2015 to a floor of 14.5 mbd in September 2016, recovered to 14.8 mbd by December, well before any expected effect of the November Agreement. The industry by the time of the Agreement was positioned to benefit from any subsequent price gains, as market analysis since then seems to indicate. These developments have brought a point home to traditional oil producers: that it will take a much lower price level to push back the oil shale industry. A level that none of the producers, due to fiscal constraints, will be able sustain long enough. This factor, is believed, was also a primary motive for non-OPEC oil producers to join the agreement.

The last but certainly not the least factor that influenced the conclusion and particularly the timing of the November Agreement was the unexpected election of Donald Trump to be the president of the United States. A nationalist and a neo-isolationist leader with pronounced support for the fossil fuel industry. The election of Trump was a game changer that shifted the grounds under whichever strategy guided the behavior of oil producers in the past. Especially, where even a perception of a price war aimed against US producers could induce the enactment of protection measures, such as an oil import tariff, aimed to protect the domestic oil industry. Such measures will likely lead to higher growth in US oil production, with resulting downward pressures on world oil prices.

Consequently, if OPEC pursue a policy of defending a price level, it then must accept a decline in its market share if shale oil producers can grow their production. This predicament partly explains the statement by the Saudi Oil Minister Khalid Al Faleh that the November Agreement is for a limited duration and aims to soak up some of the expected over supply during the First Half of 2017.

KZ

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