Saudi Oil Minister Prince Abdulaziz bin Salman recently said that OPEC+ is the central bank of oil, and that he feels good about the increase in oil prices since April.
I’m glad that someone feels good because the truth is that OPEC+ has done a dreadful job of managing world oil markets over the last three-and-a-half years. Markets have been over-supplied 79% of the time and there have been two major oil-price collapses since production cuts took effect at the beginning of 2017.
If that’s how a central bank performs, I would fire the banker!
When OPEC+ announced production cuts in November 2016, inventories had already fallen about 25% from peak levels in March of that year (Figure 1). Markets were balancing themselves and didn’t need help from the central bankers of oil.
Because of anticipated cuts, prices increased 20% in November and December from about $45 to $54. Higher prices led to a production surge and inventory builds that contributed to much lower prices by June.
To make matters worse, OPEC+ was responsible for much of the over-production that led to the late 2018 price collapse, and was at least partly responsible for the 2020 price collapse.
OPEC+ members ramped up production beginning in April 2018 in anticipation of U.S. sanctions on Iran oil exports. When Donald Trump reneged on those sanctions, prices collapsed to the lowest level since June 2017.
The producer consortium was powerless against Covid-19 and its effect on the global economy, but the group’s failure to reach agreement to continue production cuts at its early March 2020 meeting is what sent oil prices into free-fall. Covid-19 finished the job later in the month.
It is absurd to call what followed a price war because no one was buying any oil with plummeting global demand. President Trump offered Saudi Arabia and Russia a convenient way to save face following this debacle. In April, OPEC+ announced “historical” production cuts of almost 10 mmb/d which formalized what markets had already done for them.
“When they look at prices over the quarter, when they look at green shoots of demand pick-up, I think they feel good.” —Helima Croft, head of commodity strategy at RBC Capital Markets
Prices have increased to about $40 per barrel since the historical cuts in April. So, the latest OPEC+ achievement is a return to the lowest price levels since the depths of the early 2016 collapse of world oil prices.
OPEC has never had an strategy for managing markets and prices. Rather, market management has consisted of one-off negotiations among members. OPEC has only cut production five times before this year—in 1982, 1998, 2002, 2009 and 2016. These rarely involved all OPEC members and often included exporting countries outside of OPEC including Mexico, Norway and Russia even before the 2016 OPEC+ group was formed. Production curtailment is only part of market management but it is the part that gets the world’s attention.
OPEC members have few shared interests and that makes it hard to act in concert. Saudi Arabia, Kuwait and the UAE are rich enough to weather production cuts; most of the groups other members are always desperate for cash. Among Middle Eastern members there are sharp dividing lines based on religion and geopolitical rivalries.
Saudi Arabia has always been the de-facto leader of OPEC. It unilaterally cut 6.5 mmb/d of crude and condensate output between 1980 and 1985 but failed to increase world oil prices (Figure 2). Those cuts represented 12% of total world output of 55 mmb/d. A great lesson was learned by Saudi Arabia that cost oil minister Ahmed Zaki Yamani his job in 1986.
Following the collapse of world oil prices in 2014, many analysts were shocked that OPEC did not cut production. That may have been because those analysts did not know or understand OPEC’s history.
After its disastrous unilateral production cuts in the 1980s, the cardinal principle under Saudi oil minister Ali Al-Naimi was to never repeat that mistake again. He refused to cut in 2014 because Russia did not agree to join OPEC in that action.
“It was a great decision…It is a reliable policy and we won’t change it.” —Ali Al-Naimi
In May 2016, however, Al-Naimi was pushed out of power. By September, Russia had agreed to join OPEC and the decision to cut 1.8 mmb/d was announced in November and enacted in January 2017. That now appears to have been a bigger mistake than Saudi Arabia’s unilateral cuts in the 1980s.
Oil Markets Cannot Be Managed
Oil markets cannot be managed. They are too big and too complex. It is unclear that any OPEC cuts were effective either at market management or at controlling oil prices.
The oil shocks and high oil prices of the 1970s resulted in a great investment boom in exploration and production all over the world. The success of that boom left the world over-supplied with oil throughout the 1980s and 1990s. It is difficult to manage oil markets that are over-supplied by countries outside of OPEC.
Supply constraints caused the 2008 oil shock. That led to a second wave of exploration and production that produced the tight oil phenomenon. It has been this non-OPEC supply that has stymied OPEC+ efforts to control markets in this century.
If Al-Naimi’s laissez-faire approach had been followed to its conclusion, I suspect that markets would have balanced on their own. I cannot blame OPEC+ for their decision to try to rescue oil markets in 2017 but the truth is that it simply hasn’t worked.
Now there can be no going back. OPEC+ must try to manage oil markets permanently. Six price rallies have failed since mid-2018 because markets know that great spare capacity underlies the periodic illusion of tight supply. Analysts were surprised that drone attacks on key Saudi refineries in August 2019 did not result in much of a price spike. That was because markets knew there was ample supply to cover the outage.
The recent price rally is unlikely to continue past its present $40-$45 threshold for the same reason. The only way for oil prices to recover to levels that make the oil business viable again is for prices to remain low enough to finally exhaust excess supply. That will be painful for the industry and eventually for the global economy.
I suspect that Covid-19 will solve this problem and take OPEC+ off the hook. The epidemic is probably much more serious than most people imagine and its effects on the world economy will be grave.
The decline in U.S. production decline is irreversible because rig counts are only about 25% of what is needed to maintain 2019 output levels. There will be massive consolidation of E&P companies that were financial zombies before Covid-19. Many of these will likely become wards of the United States government.
Meanwhile, the fiction that something important is happening this week continues. There will be no positive outcomes from this week’s OPEC+ meetings unless avoidance of a negative outcome is considered positive.