Let’s start with a very pessimistic metaphor and then apply it to the oil market. Most patients who suffer from cancer discover the disease in the fourth and final stages — when the disease has become fatal.
The Organization of the Petroleum Exporting Countries is like a patient who discovered that they have cancer. Shale oil production in the United States increased by almost a million barrels a year over the period 2009-2013 and OPEC did not notice it. The number of shale producers exceeded 300,000 individual companies.
OPEC increased its output while shale producers added a million barrels a day at the same time.
OPEC could not comprehend the resiliency of the shale producers. Although U.S. oil drillers have idled 68 percent of their oil rigs since October 2014, shale producers increased production due to techniques they developed recently. Oil producers have cut operating costs by 35 percent in the United States and 20 percent in the world. This has helped those companies stand a much stronger blow than OPEC expected.
OPEC does not seem to understand the relationship between oil production and oil rig counts. Our research on this relationship shows that there is a lag between a drop in the oil rig count and the fall in oil output. This lag could be as long as six months. In the United States, oil rig counts dropped from 1609 rigs in October 2014 to 501 rigs in January 2016, a 68 percent fall. Correspondingly, the U.S. oil output dropped by 620,000 million barrels a day, which is seven percent of total production.
OPEC could not figure out the level of the throat-cutting price for the shale producers. A Wood Mackenzie report said that globally about 3.4 million barrels of oil a day was not profitable below $35 a barrel, which is about 4 percent of the world’s supply of 97.07 million barrels a day. The U.S. Energy Information Administration states that the price at which U.S. shale producers would be forced out of the market is lower than previously thought. Being cash negative is not a good enough incentive to force many producers to shut down their oil wells because restarting output can be very costly. Some producers are also able to store production with a vision to selling it when prices go up.
OPEC did not understand hedging in the oil market. Almost all shale producers do hedging. Currently, they use the so called three-part hedging that can protect oil price as far down as $25/barrel. This hedging strategy includes a cap price which could give protection of $65/ barrel, a price floor that may give protection to a minimum price of $35/barrel. Those two prices together are known as collar. The third part is selling put options which is known as a subfloor that can give price protection to as low as $20 a barrel. Oil companies like Callon and Pioneer Energy among others are using this technique.
When OPEC followed the market share policy, it opened the oil spigot to the maximum. The oil price plunged in a disorderly fashion and without an end in sight. Excepting George Bush’s war in Iraq, attacking countries usually plot an exit strategy before they engage in wars. OPEC does not have an exit strategy for its price war, which is really available at hand, but all what it wants is to behead the shale producers even if it has to privatize Aramco, impose taxes on their people, deplete foreign reserves and debase domestic currency.
On the demand side, OPEC was not forward looking. It has not understood the economic slowdown in the most veracious oil consumer in the world. China is struggling and has experienced a fall in economic growth to about a below seven percent rate, down from 13 percent in the good old days. There is also a continuing global slowdown, while OPEC keeps talking about a rebound in oil demand and an oil price of about $50 a barrel.
On the political side, OPEC should learn that it is not a good business to mix oil and politics because it can cause fire. If some OPEC members have political conflicts with Russia and Iran, this should not spillover to oil prices because this war will bring huge casualties on both sides of the conflict which include major opponents.
Not everyone should feel good that OPEC has a market share cancer. The oil market always needs a regulator. In the 1950s and 1960s, the regulator was the Seven Sisters and since the 1970s it has been OPEC. We need a stabilizing force that reduces volatility in the most volatile commodity market in the world. This time too much of a good thing is bad. Here in the United States lower oil prices are usually beneficial to the overall economy but this time their impact seems be different and overall negative. Their bad side has so far primarily weighed on the energy sector but it also affected a broader part of the economy.
That said, OPEC cannot continue to go in the wrong direction. Could OPEC survive its self-inflicted market share cancer and the world stop suffering as a result? It is time to reconsider strategy.