OPEC’s Dilemma

Division inside and competition from outside have weakened the cartel's ability to manipulate prices
By Daniel Lacalle, Chief Economist, Tressis Gestión
July 22, 2018 Updated: July 23, 2018    

Oil has made a spectacular comeback this year, rising from $60 per barrel at the beginning of the year to $77 in June. Regardless of what the price is, however, it never seems to be right.

When it’s below $50, the producers like Russia and Saudi Arabia are crying that it’s too low. When it approaches $80, the consumers, like Europe and the United States, say it’s too high.

For the central planners of the oil market, OPEC (Organization of the Petroleum Exporting Countries), this dichotomy can be tough to manage at times, especially because there are different kinds of producers as well.

The fundamental problem at the last OPEC meeting, at the end of June, was the evidence of a division between two groups: one led by Iran, which wants higher prices and deeper cuts, and the other led by the two largest producers, Saudi Arabia and Russia, who support a more diplomatic position. Russia plays a role in the negotiations even though it’s not officially part of OPEC simply because it can scuttle any agreement by increasing or decreasing its production. 

Iran wants to continue increasing its own production yet wants OPEC to maintain the group cuts. Iran also faces the backlash of sanctions on exports. Today, the United States exports more oil than Iran.

Saudi Arabia and Russia have the lowest production costs and stand as the ones to gain more from a moderate production increase. Oil prices will not collapse and they will sell more oil, hence making more money.

Producer Division

The agreed increase in production is a good political move from Saudi Arabia because it shows that it does not aim to harm the world economy or its customers. The goal is to return to a stabilized oil market. With this, Saudi Arabia cements its position as the Central Bank of oil.

The winners from this carefully designed agreement are Saudi Arabia, Russia, and the Gulf countries—those who enjoy lower costs and can generate higher revenues from improved exports. The agreement sets production higher but no individual quotas, so improvement in output is left to the countries with the highest excess capacity.

Iran, Venezuela, Ecuador, and other countries that have production and geopolitical problems suffer the most.

The commitment is likely to add 600,000 to 650,000 barrels per day to the market. A figure of 32 million barrels per day is agreed, but the real increase will not be the optical 1 million barrels per day, but rather the aforementioned 650,000 one.

This figure, at a time when oil inventories are in line with the average of the past five years, relieves inflationary pressures and eliminates the risk that the U.S. government will take political measures against the OPEC countries. President Donald Trump had already alerted OPEC that it could not keep inflating prices artificially.

No Real Power?

In addition to showing the tension between these two sides, the OPEC summit also revealed that the cartel has much less market control than they would like to have. The fact that the price has only reached $80 a barrel (compared to $100 to $130 a few years ago) indicates that their ability to manipulate prices to $100 per barrel is very low.

OPEC production cuts, on the other hand, have been the greatest gift to shale. Oil production in the United States already exceeds 10 million barrels a day and independent companies have strengthened operationally and financially. As such, the long-term oil curve is in backwardation and already indicates a moderation of up to $15 per barrel in the coming years.

The reason why prices were soaring recently was the artificially limited supply from OPEC as well as political risk in Iran. Now OPEC seems more reasonable, and the oil curve indicates prices closer to the fundamentals. The situation of supply, demand, and inventories is more aligned with historic levels.

The challenge from now on for OPEC and for oil producers is not to seek artificial price inflation, but to improve efficiency. OPEC cannot stop disruptive technologies, such as the electric car, and needs to stop thinking about oil prices by looking at the past and instead pursue cost efficiency and the diversification of their economies.

The big problem with OPEC is that when prices went up, they became accustomed to an unjustified oil windfall and when they went down, they faced huge deficits from unsustainable government spending, started during the boom years.

In summary, it can be said that the period of price manipulation was a failure. U.S. producers strengthened, diversification, and technology accelerated and prices barely rose to $80. Now OPEC must think about the future, forgetting an inflationary past that will likely never return.

Daniel Lacalle is chief economist at hedge fund Tressis and author of “Escape From the Central Bank Trap,” published by BEP. 

Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times.