What stocks to invest in = will an oil cartel cut production and raise prices? « PRACTICAL STOCK INVESTING



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As I argued yesterday, the oil cartel can cut oil production to a degree that will raise prices significantly, because the gap between supply and demand is relatively narrow.  Whether it will, however, is another matter.

The announcement on Tuesday of an agreement among Saudi Arabia, Russia, Venezuela and Qatar is a case in point.  The Saudis and Russians together account for about a quarter of world oil production.  Venezuela and Qatar each account for about 2%.  The four declared three days ago, after what was widely rumored to be a meeting to discuss production cuts, that they had agreed not to raise production further.  Given that the Saudis, Russians and Venezuelans are all running flat out–Qatar may be, too, I just don’t know–this was an incredibly weak statement.

Of course, consuming nations don’t want prices to rise.  Sunni countries don’t want Shiite countries to have more money and vice versa.  The rest of the world would worry that extra funds in the Middle East will find its way into jihadist hands.

There are also important economic considerations, concerning the character of OPEC and the differing motivations of Saudi Arabia and the rest of the cartel.

First, OPEC as a cartel:


Economic theory and practical experience both conclude that economic cartels never work.  That’s because members always violate any production reduction agreements they come to.  At one time, OPEC, founded in 1960, was an exception.  That’s because, in my view, in the early days OPEC was a political organization–formed to combat colonial exploitation of resource-rich third world countries.  During that period, the organization displayed remarkable cohesion.  OPEC’s nationalization of the oil companies’ interests in the 1970s, however, transformed the organization from a political detente to a garden-variety economic cartel, subject to the same garden-variety cheating problem that other commodity producers suffer from.

On top of that:

Saudi Arabia possesses vast oil reserves, enough to continue production at current rates for, say, 100 years.  Since the oil shocks of the 1970s,  Saudi Arabia’s biggest economic concern has been to maximize the value of this asset   …that is, to make sure the world is still using oil and has not substituted other forms of energy for the next century.  The main threat to accomplishing this goal is very high prices.

By and large, the reserves of other OPEC countries are much smaller–enough to last, say, 20 years.  These nations couldn’t care less about long-term substitution of other fuels, because they will have run dry before that can happen.  Having the highest possible oil price in the here and now is the most important objective.  So they have a strong incentive to cheat rather than adhere to production cuts OPEC agrees to.

Also, for the past several years, the Saudis have had to worry about the emergence of large amounts of oil extracted from shale.  That has been enough to tip the oil market into oversupply.  The expansion of shale oil output undermines the ability of the Saudis to stabilize prices, too.

In practical terms, what do these factor imply?

–although the rest of OPEC would be willing to agree that Saudi Arabia should cut oil production to stabilize/increase prices, other members are unlikely to reduce output themselves.  They’re much more likely to boost it.  We saw this clearly during the oversupply years of 1982-86.  During that time, Saudi Arabia reduced its oil production in steps by about seven million barrels a day without putting a dent into oversupply.  That’s because other OPEC nations, which had promised to cut back their output, upped it instead, barrel for barrel with Saudi Arabia’s cuts.    All the cutbacks did for Saudi Arabia was to lose it market share–which the kingdom found very hard to win back when supply and demand came back into balance.  There’s every reason to expect the same outcome would happen again.

–at a $30 a barrel market price, shale oil production in the US is gradually starting to shrink.  If oil prices remain at the current level for another year or two, shale oil firms will start to go out of business.  This means that skilled workers and technical knowhow will be lost–making it more difficult and time-consuming for shale oil production to start up again.  Arguably, this is Saudi Arabia’s main objective.  After all, if the Saudis had not increased its oil output over the past year or two, world oil supply and demand would be roughly in balance today–and prices would, I think, be significantly higher.

 

What does “significantly” mean?  When oil prices were at $100+ per barrel, shale oil producers had no need to be efficient.  They made a profit almost no matter what their costs were.  So they concentrated on maximizing production.  Estimates at the the time were that shale needed a price of $60 a barrel to be economic.  In today’s world, where shale oil drillers have got to concentrate on keeping costs in line, I think the breakeven price is closer to $40.  So even in the unlikely event that OPEC agrees on production cuts–and nobody cheats (fat chance!)–$40 a barrel is probably a price ceiling.

 

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