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Supply and Demand: The OPEC Dilemma

Factors driving down the price of oil causing deep divisions among OPEC nations!

To many, it is known as black gold - the thick sludge that gushes out of wells across the Middle East, where a huge portion of the world's oil resources are concentrated. Oil is one of the world's most precious commodities, driving industry, and providing the necessary energy to sustain the burgeoning economies of India, China and Russia. The world's gluttonous appetite for oil is insatiable, at least for now and into the foreseeable future. But various geopolitical and economic events are taking place, shifting expectations and creating a new dynamic that is forcing OPEC countries to think long and hard about how they transact with the global community. The oil price reads more like a rollercoaster surging to record highs and then plummeting to near record lows. At last count, the oil price was trading at $75.64 per barrel for West Texas Intermediate crude oil and $79.31 per barrel for Brent crude oil. This marks a sharp reversal from prices that reached as high as $110 per barrel + for Brent crude and WTI crude oil. The highly volatile commodities markets are susceptible to a wide range of global factors, including recessionary fears in Japan and Europe, divestments from emerging market economies and the possibility of rising interest rates in Western nations. But perhaps the biggest challenge to the oil price is the booming oil industry currently taking place in the United States. We will explore many of these factors and try to make sense of the oil market at this point in time.

The Price of Crude Oil on the International Markets

West Texas Intermediate crude oil (WTI), the American benchmark for oil prices, has plummeted since the second quarter of 2014. The sharp declines mirror the trend that has been taking place with Brent crude oil, the global benchmark for oil prices. In both instances, the price per barrel reached as high as $110, or more, and has dropped sharply beneath the crucial $80 per barrel level. While this theoretically bodes well for the world's biggest oil consuming countries like the US, Japan, Russia and China, it creates all sorts of problems for the oil producing countries, many of which are emerging market economies. A recent report was released by the International Monetary Fund (IMF) which details many of the challenges facing emerging market economies. For example if the price of oil remains below $90 per barrel, countries like Nigeria, Saudi Arabia and Russia will be unable to balance their budgets. While it is true that Russia and Saudi Arabia have substantial currency reserves, they are not endless. Countries like Kazakhstan and Kuwait have deep pockets, and would be able to sustain an oil price drop to $65 per barrel or less and still remain in the black.

Why Are Emerging Market Economies Suffering Under Current Conditions?

For starters, interest rates look likely to rise in the near future. This has been advanced by the Fed, and the European Central Bank and Bank of England are contemplating such notions. With the complete phasing out of the stimulus – quantitative easing – emerging market economies fear that investments will be pulled from their relatively unstable economies and pumped into developed economies. Falling oil prices cut both ways when it comes to emerging market economies. For starters, the relatively cheaper cost of oil makes it possible for balance sheets to reflect positively with lower prices. However, many emerging market economies that are oil producers themselves cannot sustain production and their economies when the oil price drops below key levels. This presents a dilemma to countries such as Venezuela and Nigeria, Algeria, Angola, Ecuador and Libya. The following graphic represents the breakeven price per barrel of oil in 2015 for a group of OPEC producing countries. It is clear from the information obtained by Deutsche Bank and the IMF, that unless oil prices rise, problems are coming: countries like Libya, Iran, Algeria, Nigeria, Venezuela, Saudi Arabia and Iraq cannot sustain oil production indefinitely at the current prices. The countries on the top end of the chart are especially vulnerable, and will likely be pushing hard to cut supply in order to raise prices.

It is evident that all countries to the right of the dotted blue line where oil prices are currently at $85 are now losing money and increasingly vulnerable as oil prices drop. The countries that are presently sitting safe, albeit barely, are Saudi Arabia, Qatar, Kuwait and Bahrain. Emerging market economies have performed incredibly well since the global recession, with an estimated 200 credit rating upgrades. However during the course of 2014, Standard and Poor’s has downgraded 33% more than it has upgraded these countries. Countries which have suffered tremendously during the year include Russia, South Africa and Brazil, and a strong reversal is now taking place in terms of the way international investors are spending their money. For the past decade, an estimated $8 trillion has gone into the stocks and bonds sectors of emerging market economies – that is no longer the case. It should be remembered that the vast majority of emerging market economies are net importers of oil, and the 30% price reductions have benefited their economies. It's the 30% of oil producing emerging market economies that are suffering. For the upcoming year, it is clear that what happens in emerging market economies is going to dominate business headlines.

How is OPEC Unity Being Tested with Falling Prices?

It should be pointed out that since 1984, OPEC – the oil cartel – has cut production 11 times. This, in an attempt to raise prices, saw an average reduction of 1.24 million barrels p/day. In every instance that oil production was cut, the price rose within 3 months. A big part of the problem is that cutting production to raise prices is like cutting your nose to spite your face. The price may rise, but it is unlikely to generate the volume oil sales that bring in the revenues that are needed. Especially vulnerable countries such as Nigeria and Venezuela will be hard-pressed to adopt such measures without addressing other issues. The flip side of the coin is that by pushing for higher oil prices, OPEC's competition – the US – will benefit. Since the United States is producing massive amounts of crude oil, global supply is at an all-time high, thereby pushing prices down. By the same token, OPEC would want to keep prices low to make oil production in the US unprofitable, especially in the infancy stages of the industry. It appears to be a Catch-22 situation where higher prices support OPEC's competition, but lower prices hurt OPEC members.

The Saudis are of the opinion that the 11 other members of OPEC would likely not commit to reducing output. For that reason, Riyadh is unwilling to shoulder the burden of reducing production, hurting its own economy, while other nations benefit from higher production volumes. The Saudis harken back to a time in the 1980s when new oil supplies were found in the North Sea in the United Kingdom. At that time the Saudi Arabians decided to cut production while all other OPEC countries continued to maintain high levels of production. It appears that the general consensus now among OPEC countries is that of collaboration, not individual cuts to oil production. It all boils down to market share, and Saudi Arabian being the world's biggest producer of oil does not want to lose out on what they believe is the lion’s share of OPEC oil supply. $80 per barrel will not allow the Saudis to achieve a balanced budget; their target range is around $100 per barrel.

The biggest driver of reduced oil prices is not the geopolitical uncertainty in the Ukraine or the Middle East; it is the US production of oil. Estimates peg US oil output at 1 million barrels per day, compliments of shale oil. Added to that is the reboot in Libyan oil production, and the Iraqi oil production. This means that there is more oil on the market, than is needed. Asian oil demand has been sliced in half, dovetailing with increased supply to reduce overall prices. The Saudi Arabians may privately be hoping to keep prices artificially low to force the US out of the oil markets by making it unprofitable for them. It remains unclear what Saudi Arabians’ real intentions are vis-a-vis low oil prices and the US shale oil production. This is clearly evident in the following graphic which shows that a substantial portion of US fracking operations cannot be sustained at the current oil price of $80 per barrel. The Mississippi lime, Delaware, Anadarko Basin, the Barnette Combo and the Utica Horizontal are all unprofitable at current price levels.

Crude Oil Barrel Prices

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