Thursday, December 18, 2014

OPEC is the new Amazon

A little historical background

The first time I ever consciously thought about oil supply was 1973. On October 6, 1973 Egypt and Syria launched a surprise attack on Israel, kicking off the Yom Kippur War. The U.S. sided with Israel and the Arab members of OPEC retaliated by first imposing price increases and then an oil export ban on the U.S.

At the time the U.S. produced less than two-thirds of its oil needs; OPEC accounted nearly two-thirds of imports. Consequently, almost 25% of our oil came from OPEC. Prices skyrocketed, refineries didn’t have enough oil, which quickly led to supply shortages. The price of oil jumped from $3 to $12. In New Jersey, we were subjected to odd/even gas rationing with long lines.(1)

During the early 1980s, OPEC used its new pricing power to set target market prices. However, because of politics, cheating and other factors, only Saudi Arabia had sufficient excess capacity and financial reserves to modify production to cause supply to match demand at the target price. Since places outside of OPEC producers were not constrained by OPEC policies, it required considerable effort by Saudi Arabia to maintain prices, and at times they were unable to do so. Price volatility was high. Eventually, even Saudi Arabia was unwilling to cut production sufficiently to maintain prices and the price of crude collapsed.

In the 1990s Asian oil demands increased substantially and prices again began to rise until a combination of increased OPEC production and a severe recession in 1997-8 caused another huge drop in prices. OPEC responded by cutting production and maintained a somewhat higher price. Demand continued to rise and for the period 2005-2008 OPEC found itself in the unique position of having no excess capacity. The 2008-9 recession solved that problem by cutting demand. Prices dropped over $100 from a peak $145.

And then came fracking

At $40 a barrel, very few investors were drilling new wells. But with increased demand came increased prices. The higher prices of oil are, the greater the number of producers that can make money. Even high-cost production becomes cost effective—like shale oil and horizontal drilling.

Oil is pouring out of North American shale oil fields. It is expensive oil. Estimates vary, but seem to average around $60 to produce a barrel of shale oil.

Over the last twelve months, the price of crude oil has dropped from almost $115 to nearly $70. Shale oil is now a whole lot less profitable than it was.

The Saudi play

Unlike some of its neighbors, Saudi Arabia doesn’t need high oil prices short term to support current budgets. Iran, Iraq, and Venezuela do. They would like the world supply of oil to decrease, forcing an increase in prices. And, they want Saudi Arabia to cut production as they have in the past.

Saudi Arabia recognizes that high prices both encourage additional production and prod consumers to find ways to save energy. Neither is good for Saudi Arabia’s long-term position as the oil power broker. With the advent of U.S. and Canadian shale oil production, Saudi Arabia has already lost most of its pricing power. However, because shale oil production from any one well dries up after only a few years, in order for the U.S. and Canada to keep producing shale oil, producers must continue to drill new wells. If the price of oil drops, they won’t drill them.

After a short period, Saudi Arabia will again be in the driver’s seat, having caused many of its smaller competitors to drop out of the market.

And doesn’t that remind you of what Amazon has done to the book market? Allowing books to sell inexpensively, and even selling ebooks below cost, Amazon drove a large number of brick and mortar stores bankrupt and increased its market share (and therefore power).

Saudi Arabia will have less success than Amazon, but that doesn’t mean its tactic won’t work. Because of the threat, investors will require a higher expected return on their investment to reflect the added risk that just as their wells enter production, prices will plummet because all the other producers are doing the same thing. This bust and boom cycle can help Saudi Arabia since they are the ones around when prices are high.

There you have it, Saudi Arabia taking a page from Amazon’s playbook.

~ Jim

(1) Consumers could only buy gas on alternate days depending on the final numerical digit of their license plate (with rules for all-letter license plates)