Too Much Oil?

At the end of last year, reputable experts were predicting that oil prices would be on the rise during 2017, and that by the end of the year they would reach the $60 mark. As time went by, however, those predictions were revised repeatedly – and each time the revisions pointed south. By the end of July, crude was selling for about $46 a barrel, almost 20 percent lower than at the beginning of the year and about half the level three years ago. Will oil prices keep dropping on persistent high supply and sluggish demand? Or will they recover, as producers find a way to limit production?

Bears and Bulls

The current scenario is relatively clear. The world economy is growing again after the latest crisis, but the scope of its recovery has been disappointing and the outlook is not particularly bright. Technological progress has ensured that we need fewer and fewer energy inputs for each unit of output, while increasing recoverable oil reserves are making them cheaper to extract. Moreover, there are wide margins for further gains in energy efficiency, especially in large economies such as China and Russia, where waste is prevalent.

Finally, oil bears take extra comfort from the trouble oil suppliers have had agreeing on a common strategy to restrain production. Ironically, while a few years ago a geopolitical crisis made the world fear that oil wells would be damaged and supplies cut, today the opposite applies. Whenever there is trouble in Russia or the Middle East, observers expect oil producers to seize upon the opportunity to increase their own production and add to the global glut.

Oil bulls point out that lower prices have affected investments in the traditional extractive industry. Yet they have hardly stopped the shale oil business. The reason is technology: according to Rystad Energy, a well-regarded consultancy, shale oil investments were profitable in 2013 provided oil prices stayed above $70-$100 a barrel, depending on the geology and location of the shale deposits. By the end of 2016, the price interval had narrowed and fallen to $30-$40. And the decline has not stopped.

In other words, oil bulls focus on declining investment and new discoveries in traditional wells on land and offshore, downplaying the role of shale oil. (Shale oil from the United States accounts for about 6 percent of global oil production and about 60 percent of total shale oil output.) If they are right, the current market glut will soon disappear: shale oil production, they claim, is unlikely to increase significantly and the existing supply will not be enough to meet demand. For example, Aramco’s CEO Amin H. Nasser predicts that global oil supply will be 20 percent below demand by the early 2020s. Oil bulls are already predicting that inventories will likely begin dropping in a matter of weeks, and that prices will rebound as soon as it becomes apparent that shale oil output has plateaued.

Supply Side

It is difficult to know what to make of this. Since the dynamic of oil demand is unlikely to change, future scenarios in the oil industry will probably be defined by supply – and it is true that the outlook for shale oil is not crystal clear. For example, producers might adopt a wait-and-see approach before deciding to expand production. They may want a peek at where oil prices are heading before starting a new round of expensive investments. This can already be seen in the behavior of several U.S. producers, who have ramped up production at existing facilities, while freezing development of new sites. However, there is also another variable at work.

Traditional oil producers generally respond to what OPEC does. OPEC currently controls about 42 percent of global oil production. As a bloc, it is by far the world’s leading producer. Yet, it has failed to execute a satisfactory cartel strategy. In the past, OPEC cut production and succeeded in raising prices, but only at the cost of losing market share to non-OPEC producers, who took advantage of the higher prices and expanded their own production. As a result, oil prices fell back to their initial level, and OPEC ended up with a smaller slice of the pie and disgruntled members.

Regardless of what some OPEC representatives claim, one can hardly overestimate shale oil’s impact. Technological improvements are unstoppable and may well extend to the exploitation of traditional oil fields. Hence, technology might create the cost conditions that allow supply to expand further. And even small fluctuations in oil production can often generate relatively large movements in oil prices.

Moreover, OPEC’s internal cohesion is fragile and its ability to collude with major producers outside the cartel (notably Russia) will be crucial. A deal with Russia could be pivotal, since it would surely boost the credibility of OPEC’s price strategy. The Kremlin’s political muscle would also prove useful to keep reluctant members in line and intimidate non-members tempted to get a free ride on OPEC’s (and Russia’s) restraint.

Even if an OPEC-Russia deal is sealed, its effectiveness will hinge on devising and executing a long-term oil strategy that would include U.S. shale producers – who have their own reasons for wanting to avoid an oil price crash. This gentlemen’s agreement (or lack thereof) would set the oil market for years to come, and possibly give new shape to global geopolitics as well.

Putin and Trump

Two scenarios could materialize. If OPEC fails to reach an agreement with key non-members, we can expect a change of strategy. Rather than striving to restrain production, Saudi Arabia and other low-cost producers will expand output. By driving prices well below $50 a barrel, they will force high-cost oil exporters to cut production and ensure that prospective shale-oil exporters think twice before entering the market or drilling new wells.

Of course, this outcome is consistent with the current market sentiment and will be welcomed by oil importers. However, low oil prices and tighter budgets in the oil-exporting countries could trigger tensions and significant political changes, since the incumbent elites will no longer command the resources required to buy consensus.

By contrast, if OPEC manages to agree on a common strategy with Russia, stabilizing oil revenue and incumbent political regimes, clearly the real winner is going to be Moscow. Russia and Saudi Arabia have already agreed to cut production until March 2018, in hope of pushing prices comfortably above the $50 threshold, and possibly to $60, which is what Russia’s economy needs.

However, oil exporters need a more stable and long-lasting alliance with Russia to become a serious factor in global geopolitics. If such agreements are reached, the real initiative will be in the hands of Vladimir Putin and Donald Trump. Global oil prices would depend on whether President Putin can offer the Trump administration enough inducements to restrain shale output (for example, by creating and enforcing a domestic cartel). The odds against this may be long, but if it happens, Russia and OPEC would find it much easier to police their own cartel and curb free riding.

Enrico Colombatto is Professor of Economics at the University of Turin and Director of Research at the Institut de Recherches Economiques et Fiscales (IREF).

2017-08-23T07:19:15+00:00

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