It Really Was A Trillion Dollar Blunder

A few days after Christmas I appeared on CNBC Asia’s Squawk Box to discuss the volatility in the oil market. Bernie Lo asked a question about OPEC’s strategy, and I characterized their decision to defend market share as “a big, costly mistake” that had already cost the group over $500 billion in 2015 and would likely cost them that much again in 2016.

I followed that appearance up with an article for Forbes called OPEC’s Trillion-Dollar Miscalculation (which went viral and received more than 100 times the traffic of their typical energy article). In that article I detailed the numbers behind my assertion.

Two weeks later, Continental Resources CEO and shale drilling pioneer Harold Hamm went on CNBC and reiterated my argument. He called OPEC’s strategy “a monumental mistake for them, I might add, a trillion-dollar mistake.” While there were a number of responses to Hamm’s comments that displayed varying degrees of schadenfreude over the huge decline in his net worth, I didn’t see much acknowledgement that the point is correct. So let’s review.

By the time of the 1973 OPEC oil embargo, OPEC’s share of global oil production had been rising for years. In 1973 OPEC was producing more than 50% of the world’s oil. But in response to the embargo, countries all over the world implemented a number of changes to gain back some degree of energy security (addressing both supply and demand side), and OPEC’s market share went on a decade-long decline. By 1985, OPEC’s share of global oil production had fallen to 27.6%, but by 1995 it had once again risen to above 40%. In 2008, just as the shale oil boom in the U.S. was beginning, OPEC’s share reached 43.8%.

From 2008 to 2014, the U.S. added nearly 5 million barrels per day (bpd) of oil production to the market. This lessened the U.S. need for OPEC’s oil, and by 2014 OPEC’s share of global oil production had fallen slightly to 41.2% in 2014.

Historically OPEC — and more specifically Saudi Arabia, which is responsible for over 30% of the group’s oil production — has functioned as the world’s swing producer for crude oil. If the world needed more oil production, OPEC could usually bring more barrels online. If the world needed less, some could be idled. The group often stressed the need for a stable oil price to ensure that global supply met global demand.

Because they were losing market share — but perhaps more importantly because they saw that trend continuing — that strategy was abandoned at their November 2014 meeting. It was then that OPEC announced they would defend market share that was being lost due to the rise of non-OPEC production, especially from the United States. Some have argued that OPEC had no choice but to defend market share instead of cutting production to balance the market, but I disagree. I think Saudi Arabia pushed for a strategy that will go down as one of the greatest mistakes in OPEC’s history. It was a decision, I might add, that 9 of the 13 OPEC members reportedly oppose.

To review, crude oil had shown signs of being oversupplied in early 2014, and by summer prices had started to soften. By the time of their November 2014 meeting, the price had dropped from about $100/bbl in mid-summer to ~$75/bbl. In making their decision, I think OPEC believed that oil prices could fall somewhat below $75/bbl for a short period of time, and that would be enough to bankrupt a lot of the shale oil companies and allow OPEC to recapture market share. Instead, the shale oil producers slashed costs, and while some producers have gone bankrupt — and other bankruptcies are undoubtedly on the way — shale oil production has proven to be much more resilient than the Saudis and OPEC expected. It is declining at a much slower rate than they anticipated.

After that November 2014 meeting the Saudis were committed, and they have reiterated their strategy at 2 subsequent meetings. To change strategies now would be to admit they had been wrong. Following that initial meeting and the 2 subsequent meetings, oil prices have dropped to lower and lower support levels. As a result the annual difference in the price OPEC is getting today for their crude, and the price they were getting prior to their November 2014 meeting is over $500 billion per year for the group.

What other choice might they have made?

At the time of their decision, the global markets were probably oversupplied by 1-2 million bpd. If OPEC had merely decided to remove 2 million bpd off the world markets — only 5.5% of the group’s combined 2014 production — the price drop could have easily been arrested and maintained in the $75-$85/bbl range. That would have still given them 38.9% of the global crude oil market. For that matter, a production quota cut of 13% could have removed from the market a volume equivalent to all of the U.S. shale oil production added between 2008 and 2014. (Whether the Saudis could have actually enforced those quotas is another matter).

Why didn’t they opt for that course of action?

I think the single biggest reason is that they were concerned that the shale oil boom would continue to expand, with production not only continuing to grow in the U.S. but in other countries with shale oil resources. It was a legitimate concern, but I think the shale oil boom in the U.S. would have peaked in a few years. With the world’s demand continuing to grow, OPEC could have just tightened up a couple of times to maintain price, and then waited for declining shale production to give them back market share.

OPEC of course reasoned that it didn’t make sense that they, the low cost producer, should cut production which would prop up higher cost producers. After all, that does seem backwards. But there is a risk in that strategy. If the higher cost producers slash costs in an attempt to survive (which they undoubtedly would), OPEC could suffer through a period of much lower prices. That is in fact what has happened.

OPEC has claimed several times that their strategy is working because U.S. shale oil production is falling. But the only way the strategy actually works is for OPEC to get back to the cash flow levels they had prior to 2014. They are a very long way from achieving that.

Should OPEC go on to gain back market share, and should they manage to maintain higher margins as a result, their strategy could pay off in the long run. The one big thing they have going for them is that they still control 72% of the world’s proved crude oil reserves — 1.2 trillion barrels. If they ultimately manage to sell those barrels and earn a few dollars more per barrel as a result of their current strategy, it could amount to trillions of dollars. (Note that because proved reserves are a function of price and available technology, their reserves estimates may plummet back to what can be produced economically at a price of $30/bbl. That will nullify much of Venezuela’s heavy oil reserves).

If OPEC’s strategy does ultimately pay off, it will be many years before it does so. It will require a huge recovery in the price of oil. It won’t be easy for them to earn back the trillion dollars in foregone revenue for 2015 and 2016. At this moment in time, it is hard to conclude that it was anything other than a big, costly miscalculation on their part. I also expect that’s what the history books will eventually say.

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