The OPEC Free Fall
There is a popular narrative going around that I want to address in today’s article. Last November, after several months of plummeting crude oil prices, the Organization of the Petroleum Exporting Countries (OPEC) met to discuss the oil production quotas for each country in the months ahead. Many expected OPEC to cut production in order to shore up crude prices that had been falling since summer. This was the strategy favored by OPEC’s poorer members, as many require oil prices at $100/barrel (bbl) in order to balance government budgets.
Instead, OPEC announced that they would continue pumping at the same rate. They chose to defend market share against the surge of supply from U.S. shale producers, and in doing so the fall in the price of crude oil accelerated. A look at the U.S. rig count shows the swift impact to U.S. shale drillers in the aftermath of that meeting:
Rig counts went into free-fall after it became clear that OPEC was not interested in propping up the price of oil for the benefit of rapidly expanding shale oil producers. While that approach hurt OPEC’s income in the short term, it also immediately impacted rig counts in the shale oil fields. But — and here is the narrative — shale oil producers continue to make gains in production even as rig counts have been slashed because they are becoming more and more efficient.
Dissecting the Narrative
There is some truth to the narrative. Yes, oil production has continued to grow even though rig counts have plummeted. The week before OPEC’s meeting last November the number of rigs drilling for oil stood at 1,574. Oil production that week was 9.1 million bpd. Today, with the rig count at 642, production is 9.6 million bpd — a gain of just over half a million bpd.
Yes, producers are getting better at squeezing oil and gas from these shale formations. And natural gas production has indeed continued to expand for years despite a sharp drop in the rigs drilling for gas.
But oil production isn’t expected to follow the same pattern as natural gas. The gains are already slowing as a result of the drop in rig counts. There have been some weekly declines in recent weeks, and the Energy Information Administration (EIA) is projecting a 91,000 bpd drop over the next month.
Bloomberg put together a nice graphic showing the expected impact in the country’s shale oil basins:
OPEC’s Latest Decision
Leading up to OPEC’s June 5th meeting there had been much speculation about the direction OPEC might go now that one of its key objectives had been achieved. Most believed it wouldn’t do anything drastic enough to shake up the oil markets again. I placed the odds of either a big production cut or a production increase at under 10%. I estimated a 40% chance that production would be left unchanged, and a somewhat greater than 50% probability of a modest production cut.
There was risk either way. Leaving production unchanged ran the risk of sending crude prices back toward $40/bbl. This would hurt the poorer members of OPEC, which have historically favored higher prices. On the other hand, low prices would continue to slow down the U.S. shale oil boom.
A modest production cut would have satisfied OPEC’s poorer countries, but would have also likely boosted oil prices toward $70/bbl. This would start to bring marginal shale oil production back online.
There were also variations of these two outcomes. OPEC could have announced production cuts but not actually made any. The organization is notorious for exceeding its production quotas, so that wouldn’t have been a big surprise. Or, it could have left production unchanged, while attempting to talk up the demand side of the equation in order to limit a marker overreaction. That is in fact exactly what OPEC did.
In announcing a decision to leave production unchanged — the same decision that led to last winter’s plunge toward $40/bbl — OPEC noted that world oil demand is forecast to increase in 2015 and in 2016, with growth driven by developing countries. On the supply side, non-OPEC growth in 2015 is expected to drop below 700,000 barrels per day, about one-third of the supply growth in 2014. With supplies expected to tighten in the months ahead, OPEC therefore saw no need to cut production.
While the exporters’ club is certainly known for self-serving statements, I believe it is correct here in noting the trajectory of supply and demand in the months ahead. Shale oil production growth is going to continue to slow (if not decline), while global demand growth will start to outpace the new supplies coming online. By leaving the production quotas unchanged OPEC is letting growing demand catch up to North American output growth, and counting on this to prevent an extended slump.
It is interesting to note that the price of WTI has already moved up 6% in the wake of the OPEC meeting. It looks like traders accept the tightening supply narrative, which runs contrary to the narrative that shale oil production will continue its growth trajectory at $60/bbl oil due to the increased efficiency of the shale oil extraction technologies.
The odds look good that OPEC will also have to accommodate production from Iran should sanctions soon be lifted as anticipated. But this won’t impact the global supply/demand balance for a few months, and is something that will probably be a big topic at OPEC’s next meeting in December.