OPEC is dead, awaiting burial

Many analysts say that the Nov. 30 deal by OPEC nations to cut daily oil production by 1.2 million barrels per day will turn out not to be very consequential in 2017. Non-OPEC Russia, a major producer, also agreed to cut production by 300,000 bpd and another 300,000 pledge is being sought from other non-OPEC countries, making the total potential cut 1.8M bpd. The additional pledges will be gained (or not) on  Dec. 10.

What was the deal? Financial Times explains:

Let's start with Bloomberg's coverage of former Saudi oil minister Ali al-Naimi:

"The only tool they have is to constrain production," al-Naimi said of OPEC at an event in Washington, D.C. "The unfortunate part is we tend to cheat." ...

He also expressed skepticism that Russia, considered a wildcard during talks, would follow through on its promise to reduce output. "Will Russia cut 300,000?" he said. "I don’t know. In the past, they didn’t."

CNBC's Jackie DeAngelis said that "Nobody really knows at this point" whether there will be cheating.

The moves in oil prices won't really take off until we learn whether members are cheating on the deal or not, DeAngelis said. That won't be until February or March, given that the deal doesn't take effect until January.

If everyone holds to their part of the deal, then crude oil prices could break past the $60-mark, according to Goldman Sachs.

But many producers both inside and outside the cartel have already been cheating. In fact, Bloomberg calls the announced cuts "fake news" for which consumers pay real money.

... Russia as a country made $6 billion just by talking to OPEC about cutting its oil output: News about the negotiations drove up the price. Now, Russia has agreed to a cut by 300,000 barrels per day by January "if technically possible." It looks like a lot -- a quarter of the total cut OPEC members have agreed among themselves -- but then Russia's output increased by 520,000 barrels a day between the end of August and the end of October, reaching an absolute record level. Russia has been making money on the increasing price while growing production -- the best of both worlds thanks to some deft news manipulation and nothing else. Now, even if Russia cuts output by about 2.7 percent of the current level, as it has promised, it will still reap a profit if the price of crude holds at the current level -- about 7 percent higher on Thursday morning than three days before.

Many years ago I visited a Toyota lot to look at used cars. There was one I looked at with sticker price of $2,999. It was attractive but too old so I moved on. Days later I returned and found balloons and banners all over the lot announcing a big sale. What did the windshield placard of that car say? "40% Off! Was $4,499, now only $2,999!"

That's what OPEC and other producers have done with production: they ran production up preparing for a deal to run it part-way down. Qatar, for example, is on track to surpass 1M bpd for the first time ever. And even if all OPEC nations fully comply with the cuts (which they never have done before), by this time next year developed nations' on-hand stocks of oil will have declined all the way from 65 days's supply to 56. That's enough for speculators and traders to make major coin between now and then, but not near enough to matter to the actual use of oil in consuming nations.

The thing about the OPEC deal, though, is that we've been here before:

This the price pattern comparison not of the direct price of crude but of an oil ETF called USO (US Oil Fund). USO tracks daily the price moves of crude at a 1:1 ratio. If oil prices rise by 2 percent, so does USO's price, and the same for falling prices. (See my Sept. 9 post, in which I explained why oil prices would rise, which they did. And then fell again, as the top chart above shows.)

Finally, the OPEC deal to set higher prices will be torpedoed by non-OPEC producers, including Russia despite its OPEC head nod, who have little incentive to cut production, and by United States shale-oil producers.

The U.S., Canada, Brazil and Kazakhstan aren't going to cut back on production, and neither is Indonesia, which left OPEC over that very matter, less than a year after rejoining it.

Financial Times chimes in,

But there is a surge of production coming in the next 12 months from new fields in countries outside Opec, such as Brazil, Canada and Kazakhstan. It is perfectly possible that total global production — from Opec and non-Opec states combined — will be higher next year than in 2016.

By far the major influence here is shale. In fact, that there was an OPEC deal struck at all on Nov. 30 is a sign of shale's growing market power and OPEC's diminishment.

OPEC isn't cutting production because it is interested or able to manage the oil market as it has in the past, it has done so because it has failed to crush the U.S. shale industry in a way that would have made it hobble along for a significant period of time, while waiting for global demand for oil to pick up.

Shale is winning

What OPEC's oil ministers doubtless realize is that shale-oil production has matured greatly in technology and economics and still has more maturing to do. Shale oil has been growing steadily less expensive to get out of the ground. Shale production has proved to be very resilient against oil-price declines despite major financial obstacles that traditional pump wells do not have: shale production rates fall per well about 70% after the first year, for example, and about half the total well costs are spent in just operating the well while traditional pump wells are very inexpensive to operate.

Nonetheless, as oil prices cratered early this year to sub-$30, shale production actually increased.

Why has U.S. shale production proven to be so resilient to low oil prices? I can think of (at least) three reasons. All three come down to costs.

First, as oil prices fell, so did the costs of drilling and completion services—more than 30% from the last quarter of 2014 to the first quarter of 2016. Because of this steep drop in costs, wells that would have been only marginally profitable in late 2014 could still be profitable in early 2016. Much of this decline in the price of drilling and completion services can be rationalized simply by supply and demand.  When oil prices fell, shale producers had the ability to drive a harder bargain with their suppliers.  After all, there was less of a “pie” to share in those negotiations, and there were fewer customers for oilfield service contractors to negotiate with.  Thus, even without changing operating procedures or drilling locations, shale producers were partially insured against lower oil prices by a fall in the costs they faced.

Second, the engineering properties of shale wells mean that “breakeven” price calculations can be misleading about the profitability of new wells in a different oil price environment. While the development costs of conventional oil wells are mostly fixed in the form of drilling an expensive hole in the right place, more than half of the cost of developing a shale well lies in the complicated hydraulic fracturing treatment that producers must employ to make these wells productive.  There is now long-standing evidence that more aggressive treatments generate more oil production. ...

Finally, shale producers are learning how to get greater bang for their buck out of drilling operations. As my colleague Sam Ori pointed out in an earlier post, producers have substantially increased the of total oil recovered in a typical well—from about 5% of the original oil in place to more than 12%. BP’s Chief Economist Spencer Dale predicts a 25% recovery factor might even be conservative five years from now. 

Here is the key point why shale is going to dominate the world oil market more and more:

As today’s shale producers continue to learn the most efficient ways of developing new wells, tomorrow’s producers in shale basins around the world will probably follow their lead.  In doing so, the emergence of a nimble and innovating global shale industry will continue to frustrate conventional oil producers eager to return to tightly controlled production and higher prices.

And so,

The reason the production cut this time around isn't going to be effective over the long term, is it has never been implemented with a mature U.S. shale industry. OPEC has never had a third competitor (beyond Russia), which is able to step into the vacuum created by a cut and quickly recover at least a portion of it.

The OPEC empire can't strike back
As mentioned earlier, this is being considered as a major aggressive move by many following the oil market, with the idea it's no different than it has been in the past. Not only is this not the case, but when shale oil production surges over the next couple of years, there is little or nothing left in OPEC's arsenal to deal with it.

What OPEC won't do is keep production cuts in place and let shale producers gain world-market share at their expense, especially since the production cuts will not actually affect worldwide supply.

FT:

Cartels need a swing producer that has the capacity to vary production to the degree necessary to control the market and which can absorb the pain of such a move. That is what they would have done in the past, but it may now be impossible, economically and politically. Saudi Arabia cannot sustain such a sacrifice, particularly given its weak security situation and its failure to diversify its economy. If that is true, the $50 price we have today is a ceiling. Opec as a cartel is over and everyone will have to get used to the new reality.

Saudi Arabia used to be the swing producer, but those days are gone. It simply cannot afford the deep further cuts necessary to raise oil prices above $60, especially since one of the key components of a cartel is dominance of the means of production. But as we've seen, those days are gone for good and so is the cartel.

OPEC, as we have all come to know and hate it, may not be quite dead yet but it's coughing up blood. From this point on governments of nationally-controlled, oil-based economies will not control the oil market. Instead corporate oil producers, sensitive to market-based supply and demand and especially to market competition, will move to the fore. It's hard to see how that can be anything but better for consumers.

Maybe 1960-2016 is more accurate.