OPEC's Pain Point

Professor of Economics
OPEC's Pain Point
OPEC's Pain Point

International oil prices increased following cuts in oil production in January, but the market has rigidly demonstrated that it remains too complex to be manipulated by just removing a limited number of barrels.

The Organization of Petroleum Exporting Countries was established to coordinate and unify petroleum policies among member countries.  Today its control over oil supply is threatened by market forces in the true sense of the word. These forces have encouraged OPEC to join  non-OPEC producers to retake control of the oil market. However it seems that the joint move is not producing the desired results.

When OPEC and non-members decided to cut production for six months  to reduce ballooning global crude oil inventories, many expected to see the inventories a thing of the past. Even though Saudi Arabia and the Persian Gulf Arab states have implemented the cuts, the inventories are still hanging around. OPEC policy became less effective when the United States stepped up its production. There is talk among OPEC and the other parties to the rare  agreement to extend the cuts into the second half of 2017. However it is simply not clear if that too will bring down inventories and push prices up.

True, OPEC has achieved 70% of the projected cuts. Saudi Arabia, Qatar, UAE and Kuwait have reduced their production significantly. It also is true that non OPEC producers are implementing 37% of the cuts, reducing the weight and effectiveness of the cuts.    

However it seems many overestimated the effectiveness of the cuts in the first place. Not every government can promise to reduce oil production. In free market economies governments are not constitutionally authorized to make such pledges. Thus as OPEC and some non-members reduce oil production, their moves encourage others to increase output.

The US, Iran, Libya and Nigeria are among countries that have actually  increased their production.  For all practical purposes, the oil market has become more competitive and more complicated since OPEC was born. No country or for the matter group of countries can determine its equilibrium anymore.

It is easy to see why some countries in the Persian Gulf are willing to extend cuts into the second half of this year. Exporting hydrocarbons  provides more than half of their revenue. The sharp drop in oil prices has made many of them vulnerable to fiscal risks, not to mention the possibility of social upheavals, with Saudi Arabia being the most exposed.

These Arab governments want higher oil prices to reduce their fiscal risk and plug gaping holes in their national budgets. However as they cut  production, other producers, visibly encouraged by rising oil prices, try to replace them in some form or fashion. Some countries may continue to cut production, but overall production is on the rise.

Since December 2016 the rig count in the US has increased by 17%. According to Dallas Federal Reserve Permian rig count is at its highest level since April 2015. The temporary increase in oil prices helped many American producers to lock in higher prices through hedging. If anything OPEC cuts seem to have guaranteed an increase in oil production in the world's number one economy. Thus, the cuts would fail to increase oil prices as much as some countries would have anticipated.

The news is particularly alarming for the Saudis now preparing the government-owned Saudi Arabian Oil Company (Aramco) for a public offering in stock markets across the world in 2018. Lower oil inventories, higher crude prices and reducing supply to create a new equilibrium in the global market would increase the value of Aramco, while reducing the risk of investing in the company.

Market forces, however, have doctrines and directions of their own and cannot be dictated anymore. The time has come for OPEC policymakers to realize that even acting successfully as a key player is simply not enough to tame oil markets.


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