Misreading the Oil Market

Professor of Economics
Misreading the Oil Market
Misreading the Oil Market

It is hardly news anymore. The Organization of Petroleum Exporting Countries (OPEC) decided not to cut oil production in their meeting last week. Analysts and observers agree that the decision is an attempt to combat the emerging shale oil industry, which has increased North America production and created a surplus in the market.

There is no question that the landscape of global energy market has changed and OPEC market share is on the decline. To protect one’s market share it is understandable to see a price war to force out the weak. OPEC members have given up billions of dollars in revenue hoping as prices decline American oil producers will suffer losses significant enough to push them out of the market. In theory this might work, but in practice one cannot help ask if the advocates of this policy have misread the market.

At first OPEC did not take the increase in shale oil production seriously to consider it a threat. More recently, at their last session OPEC oil ministers predicted oil prices to remain above $85 per barrel.            

The market proved them wrong. The US oil production is at an all-time high. Many had expected the US to become a net oil exporter by 2018. Relying on innovative research and development the Americans are certain they can reduce the cost of producing shale.

OPEC is picking a fight with some resilient businesses and its membership is already at a disadvantage. US producers already benefit from an advance financial market through which they have locked in prices higher than current market prices for the rest of 2015. It is estimated major shale oil producers have already sold three-quarters of their output at high prices. As oil prices decline US producers remain profitable and capable of attracting further investments. The same cannot be said of OPEC members. As prices plunge their governments must rush to balance their books. Their economies become more vulnerable and their bargaining position weakens.

Falling oil revenues have already created major challenges across OPEC countries. US producers vow that they can live with $50 a barrel. A recent report from the International Energy Agency considers some US producers will profit even if prices hit $42. To prepare a budget in Saudi Arabia, Iran or Kuwait for 2015 with $42 oil would be any planner’s worst nightmare.

Unlike American businesses OPEC countries have limited space for maneuverability. Their governments use oil revenues for welfare programs ranging from tuition and living expenses for their citizens studying abroad to free healthcare. Falling oil revenues mean these governments need new fiscal measures which might not be well received by their people. Their access to derivative contracts was and remains limited. In the face of their recent inaction, global oil market is expecting even lower prices. Thus, it is unlikely that the buyers would lock in at the current price level.

Let’s there be no mistake. OPEC has apparently locked itself in an oil war to protect market share. The organization is battling the newcomers hoping to eventually push them out. However OPEC is fighting the war on the terms of its strong opponents. As oil prices continue to take a beating, OPEC will face many socio-economic challenges, while its competitors, American shale oil producers, remain motivated to find new ways to reduce production costs. Using the financial markets they can promise a high return on investments, something OPEC countries simply cannot guarantee.

American shale oil producers also can appeal to their government, which is publicly committed to a program of energy independence. Using public resources and innovation hubs these producers have more than a fighting chance to survive.

Encouraged by Saudi Arabia OPEC members have committed themselves to current production levels in the fading hope of safeguarding market share. They have come to this point because since the outset they underestimated their rivals. It seems they continue to underestimate the tectonic changes in the global energy market. For their sake let’s hope they do not overplay their hand, or else heads will start rolling across the major oil capitals.