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Abu Dhabi, UAETuesday 18 December 2018

Boom-bust cycle jerks reins out of Opec’s hands

From a low of US$9.10 per barrel in late 1998, oil prices escalated almost unrelentingly to $144 in July 2008, crashed below $34 in December in the financial crisis, rebounded to $128 in March 2012 on Middle East geopolitical turmoil and have now slumped again to around $36.

During this period, Opec was allegedly managing the market. If this is stability, what would instability look like?

A provocative new paper by Robert McNally of Columbia University argues that Opec’s market management role did not end with the recent rise of US shale oil. He concludes that the producers’ organisation has not effectively stabilised prices since 2004, except for a brief period during the financial crisis.

The thesis draws together strands that have become increasingly clear. Saudi Arabia does not have enough spare capacity to cap rising prices, in the event of disruption or unexpected demand growth. And it has no intention of cutting its own production unilaterally (or with some limited assistance from GCC allies), ceding market share to geopolitical rivals or non-Opec competitors.

It is not possible for prices to be high and stable, except during temporary periods when disruptions are coincidentally matched by new supply, as in 2012 to the middle of last year. High oil prices attract too much competition – within Opec, outside Opec and from efforts to reduce oil dependency and improve efficiency. Saudi proclamations in September last year that “the high cost of producing shale oil … means the price of oil will not go to less than $90” now appear wildly optimistic.

It is possible for prices to be low and stable, as during the post-war period up to 1970, when US regulators managed their domestic market and the international oil companies’ “Seven Sisters” restrained low-cost output in the Middle East.

Prices were again low and fairly stable from 1986 to 1998, when vast Opec spare capacity prevented any rally. Equilibrium was always vulnerable to any race by a low-cost producer for market share, but sanctions and mismanagement in Iraq and Iran meant that only Venezuela tried this strategy – with ruinous economic and political consequences.

Mr McNally now thinks we are back in the pre-war era of “boom and bust”, with wild oscillations in price. That is possible, and over the next few years, we could sketch out three illustrative scenarios.

In the first, the market will take a couple of years to digest the current swelling inventories and the return of Iran. After that, the halt in investments in long lead-time, high-cost areas such as oil sands and deepwater (and the Arctic, although its importance is exaggerated), the travails of Iraq and the financial damage inflicted on shale oil companies would constrain output, and prices would reascend towards the uplands of $100 per barrel.

In the second case, a rise in prices would quickly revive the shale oil companies, leading to another surge in North American production. Volatility would remain, but the cycles would be compressed, on the order of a year or less, perhaps superimposed on the industry’s traditional decadal rhythm. Prices would fluctuate around the cost of the marginal shale producer – $65 per barrel or so.

In the third case, intense competition for Opec market share between Riyadh, Tehran, Baghdad and perhaps Tripoli and Caracas, cost reductions by petroleum companies, continuing technical innovation by shale oil producers and tepid global demand would keep prices low and rather stable, in a rerun of the 1986 to 1999 period. That would mean a lengthy, painful bout of restructuring for both the major oil companies and the big producing countries.

Is there anything Saudi Arabia and its Opec competitors could do to forestall this gloomy future? There are no easy answers, but in a following article, I will outline possible strategies.

Robin Mills is the head of consulting at Manaar Energy and the author of The Myth of the Oil Crisis