Scrap “The Call on OPEC”

Steven Kopits is the President of Princeton Energy Advisors, and has been a guest blogger on The Barrel numerous times in the past. 

Seven years ago, when I first turned my attention full time to oil, one of the strangest concepts I encountered was the “call on OPEC”.  The call on OPEC means different things in different contexts, but fundamentally, it is as non-economic and culturally imperialist a term as one could imagine.

The call of OPEC works like this.  Non-OPEC countries are assumed to produce as much as they can, guided essentially by price signals.

Whatever demand is left over can be served by OPEC.  OPEC is thus assumed to “balance the market” and the number of barrels necessary to do so is the “call on OPEC.”

Now, imagine this concept grafted onto, say, automobile production.  Suppose an American policy-maker argued that GM and Ford should produce as many cars as they like, and then Toyota could supply any demand left over.  From an economic viewpoint, this would be incomprehensible.

Why would Toyota’s motivation be any different than that of Ford?  Why would Toyota’s economics dictate a deferral of production decisions until competitors had already claimed their own market share?

And moreover, were this to be the case, the political uproar would be deafening.   Imagine the reaction if an American politician to suggest, for example, that the Japanese should really let the Americans lead in serving the market. If US car makers over-produce, the Japanese could cut production.  The reaction would be one of complete outrage—and rightly so.   And yet, when the call on OPEC has a similar effect, no one complains.

OPEC is expected to moderate its production around the activities of non-OPEC producers and consumers, because, well, we’re so important.

Now, the call on OPEC does exist for certain practical reasons.  First, the cartel is assumed to act in concert.  In theory, unified OPEC decisions can affect oil production and prices in ways that hundreds of profit-maximizing firms cannot.   Therefore treating OPEC as a kind of entity makes some sense.

Further, OPEC production decisions are assumed to be geared to meeting national fiscal needs rather than maximizing profits.  If Exxon ran, say, the Algerian oil fields, then production would be much higher than today, but the resource would be depleted much faster as well.  Profit-maximizers will behave differently than revenue-satisfiers like the OPEC countries.

Finally, Saudi Arabia is the only country with material spare capacity which can be called, and the only OPEC country with the financial reserves to buffer any lost revenues due to curtailed production.  Nor have the Saudis renounced this role.

Thus, OPEC dynamics are different than those of profit-maximizing oil companies.  Analysts, therefore, treat OPEC as a separate analytical category, and divining OPEC intentions has become a skill unto itself.

Nevertheless, OPEC has left oil markets in the lurch not once, but twice, in recent times.   The first was not the recent price collapse, but rather the price spike during the Arab Spring.  This spike was, by historical standards, of sufficient magnitude to trigger a recession, and it did in both Europe and Japan. (The US barely escaped, although the data speak to a crypto-recession in America as well.)  Saudi Arabia did respond, but too little and too late, and Saudi production additions were quickly withdrawn.

Those who thought Saudi Arabia might be willing to step up production to cover growing global demand were quickly disabused of the idea, and the analyst community came to accept that the Kingdom would probably never pump more than 10 million b/d on a sustained basis.

This assumption has proved true to date, and the belief remains intact.  The call on OPEC no longer means “sustained Saudi production over 10 million b/d.”

The recent oil price collapse is simply the mirror image of Saudi response during 2011.  If Saudi Arabia was not willing to permanently increase production at that time, there was no compelling reason to think it would permanently cut production now.

And that’s the key word: permanently.  For those who know their history, the Lessons of ’79 dictate that Saudi Arabia would be poorly served to cut production in the face of a structural increase in supply or decline in demand.

Such action would lead to a death spiral of production cuts, in which Saudi production cuts are followed by increased non-OPEC supplies and falling demand, leading to further Saudi production cuts, and so on, with the Saudis facing both low prices and low production at the end of the day. This is exactly the narrative from 1980 – 1985, and the Saudis have not forgotten it.

Thus, the only surprising aspect of Saudi resistance to production cuts is that anyone thought the Kingdom would meekly cave to international pressure.  They haven’t.  But the pressure has been immense, and Saudi Arabia has taken the blame for low oil prices, completely without justification.

As can been seen on the graph below, Saudi oil production is only modestly higher than its level three years ago, and lower than in either 2012 or 2013.  Indeed, Saudi production is lower than the same period last year.   The Kingdom has actually cut production, even if not by much.

And that’s true of OPEC as well.  OPEC output would be all but unchanged since 2011 for all but the recovery of Libyan output since the middle of 2014, and again, OPEC output is lower than its level in 2012 and much of 2013.  If the Saudis are blameless, so is the rest of OPEC.

 

If we are  looking for an aggressor, look no farther than US shales.  As the graph above so vividly shows, US production is more than 4 million b/d more than its 2011 level.  The US shale producers are the ones upsetting the apple cart.  They are doing the attacking, and Saudi Arabia is merely holding well-established production levels.

And here’s where the call on OPEC becomes so damaging.  It creates a mindset that somehow Saudi Arabia is supposed to roll over and reduce its output so that US shale producers can make a good living. For example, Gary Shilling, a normally sober-minded analyst, is prompted to write:

Normally, less demand and a supply glut would lead the Organization of Petroleum Exporting Countries, beginning with Saudi Arabia, to cut production. As the de facto cartel leader, the Saudis would often reduce output to prevent supply increases from driving down prices. 

OPEC, in effect, is challenging other producers to a game of chicken…

The Saudis also seized the opportunity to damage their opponents, especially Iran and what they see as Iran-dominated Iraq, in the Syria conflict.

One is left with the impression that the Saudis crashed oil prices by flooding the market with cheap oil, and that the Saudis are responsible to fix the problem.

Nothing could be farther from the truth. The Saudis have cut production, not raised it, and Saudi—and indeed, OPEC—production is materially unchanged in three years.   And yet Shilling would have us believe that it is Saudi Arabia who is playing chicken or has taken some extraordinary steps to confront Syria or Iraq.

And why is that?  Because of the call on OPEC, which creates the presumption that Saudi Arabia will balance the market, regardless of whether that serves Saudi interests or not.

No one is calling on the Russians to balance the market (which actually makes more sense).  Why is that?  Because there is no “call on Russia.”  If prices are low, the Saudis must be shirking their obligations, or they have some nefarious intent, so the thinking goes.

Now, the Saudis do have interests and enemies, and certainly they are an important actor in oil markets.  And Saudi Arabia, possessing virtually the only discretionary spare capacity in the world, is still reasonably positioned to compensate for over- or under-shooting in the market.

In the case of temporary outages, as during the Libyan revolution, the Saudis can add production help prevent an oil price spike.  When there is a glut, and the oil price is materially below marginal cost, the Saudis can cut production to help sustain prices.

In fact, we have such a situation now, save that no one is really sure what marginal cost or marginal production rates could be.  We simply don’t know how much shales can produce, at what pace and what price.

The Saudis, therefore, are allowing price discovery, painful as that may be to US oil producers and OPEC budgets.

Therefore, in a narrow sense, the call on OPEC still has some meaning.  Saudi Arabia can still cut around the margins, when prices are unnaturally low or high and the market dislocation is temporary.

But the cost is too high.  The call on OPEC creates the illusion of duty by the Saudis where none exists—nor should it. It allows investors and oil companies the mistaken sense of security that Saudis will subordinate their interests even when the math flatly contradicts the proposition.

In short, whatever benefits the call on OPEC may have had in the past, today, it is more of a liability than an asset.  It is time to scrap the whole notion.

platts