By: Kara Lilly
When my siblings and I were young, my parents often took us on long road trips throughout Canada. Five kids would pile into a beat-up blue van and we’d hit the road, making a quick stop at the closest gas station to fill-up on gas and junk food. My father would grumble about the price of oil as one of the kids leapt outside to fill up the tank.
I knew little about oil markets back then except that prices were volatile and liable to upset my father. It was only through the nightly news that I ever heard about OPEC and its seemingly omnipotent influence on the price of gas in my neighbourhood. At that time, OPEC was a mere background fixture in my reality.
How the world changes. After decades at the helm of global oil markets, OPEC appears to be relinquishing its status as designated ‘swing producer.’ This is a big deal if it occurs as it would mean the OPEC we used to know is dead. It would also likely mean greater volatility in oil markets and geopolitical change.
The Historical Role Of OPEC
The Organization of Petroleum Exporting Countries (OPEC) was formed in 1960 with the mandate to “co-ordinate and unify the petroleum policies” of its members and to “ensure the stabilization of oil markets in order to secure an efficient, economic, and regular supply of petroleum to consumers, a steady income to producers, and a fair return on capital for those investing in the petroleum industry.” In other words, an oligopoly was formed to stabilize prices and ensure an environment in which adequate economic profit was being generated. OPEC’s formation also had the added benefit of increasing the international political clout of its members.
How was OPEC able to accomplish all this? It did so by taking on the role of swing producer.
The economics of commodity markets are simple at a high level. In the short-term, the forces of supply and demand result in prices that often fluctuate significantly. In the long-term, prices tend to move towards the marginal cost of production. That is, the long-term price of a commodity theoretically is the price at which the marginal producer is only just making a profit. Yet, these dynamics have traditionally been distorted in oil markets due to OPEC.
As swing producer, OPEC decides when it wants to increase or decrease production, thereby influencing the price of oil. If the price of oil is deemed too high or low (or a geopolitical objective is sought after), it might manipulate supply like it did in 1973 and 1977 when it cut production, and in 1986, when it flooded the market with oil.
Historically, these production changes have mostly been driven by Saudi Arabia: the largest member of OPEC, its true helm, and the only country that never ‘cheats” when lower production targets are selected (i.e., Venezuela often agrees to production cuts, but then proceeds to produce as much as it did previously).
But now OPEC (read: Saudi Arabia) appears to be passing this mantle. The question is to whom and why.
The Rise Of U.S. Oil Shale
If there is a player that has significantly transformed oil markets in the last five years, it is the U.S. shale producers. These players produce oil from unconventional resources which have historically been more difficult to reach at a reasonable cost. Their production has exploded in recent years as technology has dramatically reduced the cost of extraction.
There are indications that Saudi Arabia might be passing the swing producer mantle to these guys. Why? One explanation is that U.S. shale producers are ‘short-cycle’ – they take a shorter period of time to ramp up or down. And this creates a very different scenario than the one with which Saudi Arabia previously contended.
In the 1970s, the marginal players in oil markets tended to be those in the oil sands or deep-water. These kinds of projects are ‘long cycle,’ meaning that they are highly complex and take years to ramp up or down. The conventional ‘wisdom’ is that long-cycle producers don’t make good swing producers. Such long-cycle projects take a long time to react to prices, meaning scaling development (and thus production capacity) up or down takes many years to realize. You don’t want a swing producer that swings like the Titanic turned.
U.S. shale producers are different because many of them are on a similar part of the cost curve, yet they are short-cycled. Unlike an oil sands or deep-water project, an oil shale (or tight sands) well typically produces over 60 per cent of its oil within the first 18 months. The decline rate on the well is high and the lifespan of the asset relatively short. This makes U.S. shale producers a decent fit for the swing producer role.
The rise of U.S. shale producers is a common explanation for an OPEC paradigm shift. Of course, it is one of several possible explanations. Perhaps Saudi Arabia simply wants to lift targets, produce more oil, and generate more revenue. Perhaps they are doing President Obama a favour in his battle against Putin, as some conspiracy theorists suggest. Or maybe they have something entirely different in mind. We simply don’t know.
But what we can say is this: if Saudi Arabia is relinquishing their swing producer status, then U.S. shale producers are the most likely players to take their place.
So let’s imagine for a moment that the throne is being abdicated. What could be the consequences?
The first consequence of such a shift would be pain for U.S shale producers. Saudi Arabia’s massive low-cost asset base means that it can stomach the role of swing producer rather well; when it cuts production, revenues go down, but the royal family still lives in its palace. Yet U.S. shale producers will not so easily withstand their new role. For those companies engaged in North America’s marginal assets, the fallout is bound to be less sanguine; companies with significant debt are likely to breach their lending covenants as their cash flows falter, while companies with low-quality assets or management teams that are perceived as weak, will likely see their access to capital markets dry up. Bankruptcies and assets sold at fire sale prices would likely result.
The second impact would be greater oil price volatility. While the assets of the newly ordained swing producers are short-cycle, they are not as short cycle as the Saudis five million+ barrels per day. Slower reaction to periods of over and under supply is likely and, therefore, so is increased volatility.
The third impact would be geopolitical. While the politics of oil are beyond the scope of this blog, it is hard to imagine that geopolitical change doesn’t occur. If OPEC abandons its swing producer role, countries will be free to produce as much oil they want and their individual share of the market will increase. But will they still retain the same degree of influence?
Moreover, there will clearly be consequences in the short-term. Russia and Venezuela are two countries facing severe economic hardship because of low oil prices. Both are governed by less-than-democratic leaders. While it’s impossible to predict exactly how low oil prices will impact these countries, OPEC’s failure to cut production and support prices will certainly be significant.
So what would a world without OPEC look like? In a word, it would be different. OPEC has been a fixture of international affairs since the 1960s and its death would carry political consequences, even if the specifics are yet unknown. Moreover, one expects oil price volatility to increase in such a scenario. For most companies, consumers and countries around the world, the additional volatility of oil is bound to be a headache. Paying at the pump might have become just that much more unpredictable.
Kara Lilly is the investment strategist for Mawer Investment Management Ltd.