For economists, it has been fascinating to watch what’s been happening in the oil & gas market since OPEC’s meeting in November, when it decided (driven by Saudia Arabia) to maintain production of 30 million barrels of oil per day. This decision, combined with the sharp rise in U.S. production and a decrease in demand driven from China’s slowing economy, has sent oil prices to their lowest levels since May 2009. Saudi Oil Minister Ali al-Naimi has explained that OPEC’s reason for maintaining the production level is to recoup market share lost to what he considers high-cost or inefficient non-OPEC oil producers, such as Russia, Brazil, and Canadian tar sands producers. Of course, there’s also a geopolitical side to the story, but let’s take a deeper look at the situation in economic terms.
The demand for oil is fairly inelastic to price; that is, as the price changes, demand stays relatively consistent, especially in developed countries. As such, OPEC has been able to essentially set the price of oil by choosing how much to produce. Over the past 5 years, however, non-OPEC oil production has exploded, especially in the United States. The country, which was OPEC’s biggest customer only 10 years ago, is now the world’s largest producer of total oil (crude and natural gas liquids) and moving toward self-sufficiency.
OPEC has typically responded to increases in non-OPEC oil supply by cutting its own production in order to keep the price of oil above $80 per barrel. Now it appears the oil market and OPEC have reached a turning point as the huge influx of supply and a slowing of demand growth from China and Europe (among other reasons) have sent the price of oil on a steady decline since June.
At the meeting in November, OPEC ministers faced unenviable choices. They could cut production in order to raise the price of oil and increase their margins in the short term, but this would not have served them in the long run. If only OPEC cuts production, not only do their competitors share the benefit of higher margins, but also OPEC concedes more market share. Instead, OPEC decided to forego profits in order to thin out the herd. By declining to cut production, the Saudis hopes to drive higher cost producers out of business while giving oil-consuming economies a shot in the arm.
Thinning the Herd
As my colleague Richard Martin has pointed out, the stronger members of OPEC (i.e., Saudi Arabia and Kuwait) can likely withstand drastic price declines, while the weaker members (Venezuela, Iran, Nigeria, and Algeria) could face economic disaster.
The current market trajectory will end up benefiting those countries that have a comparative advantage in oil production, as it should, and it’s likely that the market will be left more efficient and better off in 2 to 5 years as a result. According to some, the U.S. might actually be better positioned for a price war than Saudi Arabia, which as a society has grown accustomed to the benefits of $100/barrel oil. According to Naimi, we may never see $100/barrel oil again. As far as he’s concerned, Saudi Arabia and OPEC will see this price war through, regardless of how low it goes: “Whether it goes down to $20, $40, $50, $60, it is irrelevant.”
As for the effects of all this on the natural gas market and renewables, that’s for another blog. The December issue of Navigant’s NG Market Notes includes a great infographic about the breakeven prices of oil for producers around the world.