In the current situation of entire economies being paralyzed by the coronavirus outbreak, you would think oil producing nations (like everyone else) have enough to worry about. With much economic activity including international air travel coming to a standstill, the loss of demand is enormous. Nevertheless, OPEC and Russia not only failed to come to a new agreement on production cuts to balance the loss of demand, but even embarked on a price war. Why did they do so? What can we expect to happen next? In this blog we will try to shine some light on this matter and take a brief look at history to see what parallels we can find.
OPEC and its objectives
The Organization of the Petroleum Exporting Countries (OPEC) was founded in 1960 in Baghdad by the first five members (Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela), and headquartered in Vienna since 1965. Currently it has 13 member states, with apart from the founding members also the United Arab Emirates and seven African countries. The OPEC members account for approximately 40 percent of the global oil production and even 80 percent of the world’s proven oil reserves. A very substantial share, giving OPEC a major influence on global oil production and prices.
The idea is simple; rather than competing for market share and undercutting each other’s prices, it is better to coordinate and agree on desirable production and/or price levels. The same would be true for rivaling companies competing in the market, however at the cost of consumer interest, which is why for companies it is prohibited to coordinate. This is enforced by (national) competition authorities that can impose fines on companies that fail to comply with these rules. However, competition authorities do not have jurisdiction over other nation states and the actions of these nation states are up to their own discretion.
Prisoner´s dilemma
But what sounds easy in theory, can be quite complicated in reality. Maybe not so much in good times, when high demand and high prices tempt oil producing nations to increase their production. In this type of market situation, the need for production cuts is not pressing, and in any case additional production might be tolerated to counter price increases because stable, sustainable prices are in the interest of oil producers rather that strong ups and downs.
Things change in situations with low demand and weak prices. In this situation oil producers are hit twice; they must limit their production to comply to production cuts and they have to sell their oil at low current market prices. Ideal in this situation would be that other countries reduce their output, supporting prices, while the individual country itself can increase its output to generate more revenues. Obviously, this is true for each individual country. Here is where the need to coordinate and to agree on output restrictions arises. But when it is not possible to coordinate, for example because of a lack of trust between countries, countries enter in a classic prisoner´s dilemma. In this dilemma the group of countries would be better off if they coordinate on output reductions. However, if countries are not confident about other countries´ actions, they can only optimize their own actions. In this case the optimal action is to increase output. If other countries reduce their output, great: prices are supported, and the increased output revenues are good. If other countries are also increasing output, at least the individual country is not the only one restraining itself. Since each country has the same reasoning, it is certain that the outcome will be the disadvantageous equilibrium where everyone is increasing output. (Side note: the prisoners dilemma got its name from the situation in which two burglars get caught and they end up both confessing because they do not want to be the only one not confessing and getting the highest sentence, even though they would be best off if they both refuse to confess).
Russian and Saudi Arabian leaders in better times (source: Al Jazeera, 2018)
Saudi Arabia and Russia
OPEC negotiations and country motivations can be much more complex than the simplified scenario described here. However, it can be very well true that Russia was hoping that OPEC would do the dirty work for it and that OPEC would impose production cuts on itself to support prices, while Russia would keep its hands free to increase production to generate revenue. And it is no coincidence that this situation where prices were already under pressure led to the pact between OPEC and Russia falling apart after three years. And Saudi Arabia´s decision to retaliate by increasing its production can indeed be seen as the expected counter move, although it seems rather disproportionate. What is certain is that both countries are worse of, at least in the short term. Saudi Arabia might hope its strong response will prevent Russia from choosing its own course in the future, but this remains to be seen and is at least doubtful.
Previous important moments in which OPEC was faced with falling oil prices:
1985-1986: OPEC cut production in the early 1980s to support oil prices, with Saudi Arabia taking responsibility for most of the cuts. But prices, which were above $30 per barrel in 1980, still slipped amid rising production by non-OPEC countries such as Norway and the US (in Alaska). Frustrated by losing market share and trying to punish excess producers within OPEC, Saudi Arabia increased production, initially driving oil prices below $10 in 1986. Prices slowly recovered from the lows, in part by forcing international major oil companies with higher costs than OPEC to delay the development of new projects.
1997-1999: OPEC increased production in 1997, as Saudi Arabia’s oil minister Ali Naimi said the increase was necessary to meet growing demand from China. But the Asian financial crisis and OPEC overproduction led to a collapse in oil prices to around $9 per barrel in 1999 as demand collapsed. OPEC announced three production cuts between April 1998 and April 1999, withdrawing 4.3 million barrels per day (bpd) of oil. The cuts were accompanied by a Saudi ultimatum to Venezuela and other OPEC producers to stop producing more than their quota. In addition to the OPEC cuts, the Vienna-based group also helped oil prices recover by securing pledges of cuts from several non-OPEC producers, including Mexico, Norway, Oman and Russia.
Milestones in evolution of oil prices (source: Reuters, 2020)
2008: The global financial crisis gave the market one of the biggest shocks in the price of oil, as crude oil fell from a peak of 147 $/bbl in July, to 36 $/bbl in December. Between September and December, OPEC held three meetings in which the group agreed to withhold 4.2 million bpd from the market. From early 2009 on the price started to recover.
2014-2016: The booming US shale production had been gaining market share on OPEC since 2012. But even as prices began to fall, Saudi Arabia did not reduce output to avoid losing more ground. Oil prices fell to almost $27 in 2016 from over $115 in 2014. Faced with budget restraints, Saudi Arabia and Russia worked together to create an informal alliance of OPEC and other producers, called OPEC+. The group agreed to its first cuts in 2016, and in January 2020 the cuts totaled 2.1 million bpd, with Saudi Arabia again making the deepest cuts. The cuts managed to give some support to prices, until the outbreak of the coronavirus slashed demand and the agreement between OPEC and Russia fell apart.
How will this continue?
Prolonged periods of time with price levels of around 30 $/bbl is something we have not seen since over 15 years ago increasing demand in China started to be an important factor in the global oil market. Before that time, we used to see prolonged periods of oil prices of around 20 $/bbl, although it is important to mention that we are talking nominal terms here, incomparable to 20 $/bbl nowadays. What is certain is that very few producers, if any, are comfortable at the low current price level. American shale oil is profitable from about 50 $/bbl, Russian oil drilling is said to need prices of about 30 $/bbl to be profitable, while Saudi Arabia has relatively easily accessible oil reserves and con do with even lower prices. However, both Saudi Arabia and Russia need the income from oil (and other natural resources) to finance government spending, so that even if current low prices are not enough to stop drilling, they do cause other problems especially in the medium/long-term. Current low prices will also affect new exploration efforts, leading to less production capacity in the future when maybe demand has picked up and prices could shoot up again. Thirdly, as you can read in the box on other moments in which OPEC was confronted with falling oil prices, OPEC tends to eventually close ranks and agree on new production cuts in difficult times, although this could take time. Based on these arguments, current low prices are not sustainable in the medium/long-term. In the short-term the evolution of prices will depend on the development of demand factors (most importantly the coronavirus) on one hand, and the actions of Saudi Arabia and Russia on the other.
What to do?
It is hard to foresee what the actions of Saudi Arabia and Russia in the short-term will be, but it is for sure that for neither country defeat is acceptable. With current low prices it is therefore worth considering leaving short term positions unhedged. Demand worries over the still widening coronavirus outbreak are an extra argument for that. For gas contracts indexed to half year averages of (Brent) oil prices, current low oil prices are likely to result in favorable third and fourth quarter gas prices.
But it is also important to look beyond the short-term. Current low prices will eventually prove to not be sustainable. The current market situation is therefore a good opportunity to secure low price levels for the medium-/long-term before the market starts to recover. We therefore recommend keeping a close eye on the developments in the oil market and the regular updates we provide.
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