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Decentralization of crude production is forcing OPEC states to start a psychological adjustment

Petrostrategies, February 1^st, 2018

OPEC and its allies (with Russia at the forefront) are successfully implementing the “mechanical” part of their efforts to re-balance the oil market. This involves reducing excess commercial oil inventories by limiting supply, and lowering commercial inventories in the OECD zone to their average level during the five-year period between 2012 and 2016. According to Saudi Oil Minister Khaled Al-Falih, speaking in Muscat (Oman) on January 22, 2018, excess oil inventories fell to 120 MMb in late 2017, as compared to 340 million barrels in early 2017. “We're uncertain that the pace of inventory drawdown will continue in coming months”, said Falih. Remarkably, the Saudi Minister was thus giving a joint interview, for the first time, with his Russian counterpart Alexander Novak, thus highlighting their close partnership.

The close collaboration between Falih and Novak, and the climate of mutual trust developed by the two men, has proved to be the cornerstone of the successful cooperation between OPEC and non-OPEC countries, initiated in Vienna on December 10, 2016 (although the ultimate decisions are of course made by their respective Heads of State). According to the Joint OPEC - Non-OPEC Ministerial Monitoring Committee (JMMC), the production-limitation agreement’s average monthly compliance level was 107% in 2017. It started at 87% in January 2017, but reached 129% in December, said the JMMC after its latest meeting on January 21, 2018. With Novak’s approval, Falih said on January 22 that the oil-exporting countries should keep production limitations in place in 2018, as the market may re-balance at the end of the year.

Falih and Novak now have their sights set on a horizon beyond 2018. “The world’s two main oil producing and exporting countries can continue their cooperation for the good of the crude industry, for the good of stability”, said Novak. For his part, Falih said that: “As we approach the re-balancing by the end of 2018, we need to extend the (cooperation) framework but not necessarily in the production levels. There is a readiness to continue cooperation beyond 2018... The mechanism hasn’t been determined yet, but there is a consensus to continue”. The Minister stressed that all interested parties should understand that the cooperation between OPEC and non-OPEC countries “is something that is here to stay. And we are going to work together”.

The oil-exporting countries need time and imagination to design a “mechanism” which they can adopt for the future Because they are entering uncharted territory. In 2017, they were able to draw on experience acquired during many previous attempts to limit production, and which met with varying degrees of success. For OPEC member-states, the first experiment in “production programming” even dates back to July 1965! But compliance with agreed production levels has never before been as good as in 2017. Russia, in particular, has never before kept its promises to limit production. So what lies behind this demonstration of joint discipline and close cooperation in 2017?

There are two reasons. On the one hand, shale oil and the abundant global supply of conventional and unconventional oils seriously threaten the trade positions of countries which comply with the production-limitation agreement of December 2016. On the other hand, there is also the approaching peak in oil demand which is now beyond doubt. “Peak Oil” could occur at some time between 2030 and 2035, more or less. Oil demand will certainly not fall sharply after that, but the cake that producers will have to share is destined to become smaller and smaller at the very moment when producible resources have never been so abundant.

Countries which are too dependent on oil revenues are thus caught between the proverbial “rock and a hard place” (shale and peak oil) and have no idea how to deal with it. This is why they are searching for a “mechanism”. They no longer talk about eliminating the most costly oils from the market, as they did in 2014 and 2015, during the tenure of Falih’s predecessor at the Saudi Oil Ministry, Ali Naimi. They have now understood that this is impossible, although the lesson cost them several hundred billion dollars in lost oil revenues. Today’s watchword is “coexistence” with these competing oils. But the question is how to coexist with shale and tight oils which depend on very different business models to those of conventional oils? Although OPEC’s Secretary General called on US shale-oil producers to cooperate in balancing supply and demand, such a prospect was purely a utopian fantasy, as he well knew.

According to the most reliable estimates, resources in place of shale oil and tight structures are larger than the resources in place of conventional oils throughout the world. So everything depends on the producibility of these various types of oil. The average recovery rate of conventional oils is about 40%, while that of shale oils is around 10%. A shale well yields most of its production during its first two years of operation, with a peak occurring within the first few weeks. The investment and operational phases are almost indistinguishable. On the other hand, a conventional oil well has a far longer production lifetime of several decades, or even nearly 100 years in some rare cases. Production of shale oil is far more sensitive to prevailing prices and costs than that of conventional oils during the operational phase: this is an advantage which favors the latter. On the other hand, the former can react to changing circumstances far more quickly, which is an advantage in their favor.

The production costs of OPEC and its allies are often far lower than those of shale producers. Their marginal costs are sometimes four or five times lower than those of shale producers. However, the significance of these marginal costs is purely theoretical due to the very heavy dependence of the exporting countries’ economies on oil revenues. In other words, they can’t reduce prices to their marginal costs, as their economies would not survive such a step. On the other hand, by eliminating excess oil inventories, OPEC and its allies can gradually regain the influence lost in setting prices. However, their degree of imprecision in setting prices remains quite broad, at more or less $10/b, due to geopolitical hazards and other uncontrollable factors which influence price-setting.

For OPEC and its allies, the big question is where to set the price cursor? If OPEC members and non-members had limited themselves to considerations such as the production levels and revenues required to balance the budgets of exporting countries, this issue could have been resolved by an economic and political consensus. However, it is complicated by the fact that the post-oil era is starting to appear on the horizon. The closer this prospect gets, the larger the incentive for countries with reserves to produce them, for fear of being lumbered with them forever, uselessly stuck in the ground.

The OPEC member-states are currently undergoing a process of psychological adjustment. They once saw themselves as the masters of the oil game, setting and re-setting prices, with some of them even using oil as a political weapon under certain circumstances. They must now acknowledge that oil production is becoming widespread and decentralized throughout the world, and then draw the appropriate conclusions. This is not yet happening. For instance, to give only one example, some producing countries are still selling their crude at “official prices”, set retroactively by means of outdated bureaucratic mechanisms. They all admit that they need to follow the market more closely, but don’t yet know how to get rid of the political and administrative burdens inherited from the past. Above all, they need to speed up the transformation of their national economies so that they are less dependent on oil revenues. But that’s another story.