Has OPEC become predictable? ^{Избранное}

The profit-maximization principle makes it easy to understand the rationale behind recent OPEC decisions

DR. ALEXANDER MALANICHEV, NEW ECONOMIC SCHOOL, MOSCOW

OIL PRICES had been hovering over US$100/bbl until the first half of 2014. Since July of 2014, prices started to decline and by 2015 WTI averaged just $49/bbl. Unlike the situation in 2008-09, oil prices did not bounce back quickly with a revival in demand (see Figure 1).

The current period of low oil prices appears more prolonged and is similar to events 30 years ago. During that period, the oil price drop was driven by excess supply, and prices remained at a low level for about 15 years.

It is believed that the current oil crisis is caused mainly by rapid supply growth both from conventional and unconventional sources. Oil extraction was expanded primarily by conventional oil producers in the Middle East and by unconventional shale oil producers in the United States. Shale oil production in the USA has increased from negligible amounts seven years ago to more than five million barrels per day (MMb/d) today.

The appearance of the vast new North American supply source, which can be accessed within a relatively short lead time, has likely influenced decision making by the traditional oil market regulator, OPEC, and its leader - Saudi Arabia.

In the face of historical supply interruptions or demand surges accompanied by the oil price increase, Saudi Arabia has often responded by increasing its production to help balance demand and supply in the oil market. During the first Gulf War (1990-91), the Venezuelan strike and the second Gulf War (2002-03), Hurricane Katrina in 2005, the surge in China's demand in 2004, and the Libyan crisis (2010-11), Saudi Arabia increased its production to ensure that demand for oil was met in the face of declining supply from other sources. Similarly, at times of weak or declining global oil demand or supply recovery, such as the Asian financial crisis in the end of 1990s or the global financial crisis in 2008-10, Saudi Arabia scaled back its production in response to market conditions by 1.6 MMb/d and 1.4 MMb/d, respectively.

In spite of this historic role as an oil market regulator, at the OPEC meeting in November 2014, the organization retained its quotas of oil production. Moreover, actual production continued to exceed official quotas. Saudi Arabia declared the strategy of market share defense. Many market observers did not expect this outcome because the strategy could have led to the tangible deterioration of economic situations of organization members.

Because of oil price descent and the disengagement of OPEC, drilling activity in the US shale oil plays was set to decline (see Figure 2). Rig counts peaked in October 2014 at 1,309 units and then collapsed to 579 units in June 2015. A sharp decrease in drilling caused a slump in new wells put into operation. Shale oil production peaked at 5.47 MMb/d in March 2015 and then began to decline.

In spite of the US production decrease, new production from Iraq continued to depress oil prices that plunged to $30/bbl in February 2016. The price meltdown was amplified by lifting sanctions imposed on Iran that considerably ramped up its exports since January 2016.

All these developments had a profound influence on OPEC economies. The problem of double deficits (trade balance and budget) had appeared. The lack of export revenues has put pressure on national currencies. The probability of social unrests and political instability has increased in OPEC countries with enlarged double deficits - notably Algeria, Angola, Ecuador, Libya, Nigeria, and Venezuela. Oil extraction has slowed in all these countries.

In March 2016, prices began to bounce back, but within three months, the US rig count bottomed out at a level of 262 units in May of that year. At that point, drilling activity in the USA started to grow, but production continued to slide.

By the end of 2016, it seemed OPEC's strategic goal had been met (see Figure 3). The organization preserved its share of the global oil market. Crude oil production in the US dropped by one MMb/d from April 2015 to September 2016. However, oil prices sat near $45/bbl, the global market was still oversupplied, and oil inventories exceeded a five-year maximum.

Under these market conditions, at the OPEC meeting in November 2016, the 171st Ministerial Conference decided to reduce its production by around 1.2 MMb/d to bring its ceiling to 32.5 MMb/d, effective Jan. 1, 2017. OPEC's stated motivation: "Current market conditions are counterproductive and damaging to both producers and consumers, it is neither sustainable nor conducive in the medium- to long-term. It threatens the economies of producing nations, hinders critical industry investments, jeopardizes energy security to meet growing world energy demand, and challenges oil market stability as a whole."

Libya and Nigeria were excluded from the deal, and Iran was permitted to ramp up production by 0.09 MMb/d.

This agreement was reached following extensive consultations with 11 key non-OPEC countries, including the Russian Federation. Non-OPEC countries contributed with a reduction of 0.6 MMb/d.

The market reacted to the news and oil prices jumped by $10/bbl. By the end of the first quarter of 2017, OPEC demonstrated excellent discipline in implementing the agreement. However, the fast rebalancing of the global oil market was hindered by three factors: sluggish demand, delay between production cuts and oil delivery, and continued growth in US shale oil production.

Thus, global inventories did not decrease in the first quarter of 2017. At the May 29 meeting, OPEC decided to extend its production adjustments for a further period of nine months, with effect from July 1, 2017. Market participants seemed to expect more production cuts, and oil price dropped 5% after the decision was announced.

Coming back to the beginning of the period under research, I should note that there is still no consensus regarding the actual reasons behind OPEC's initial decision at the meeting in November 2014 to not cut production. Explanations given by analysts fall into three categories:

• OPEC flooded the market with crude in an attempt to defend market share and drive out shale producers;

• Shale oil has taken OPEC's role as the swing producer and its members were forced to accept low prices;

• Uncertainty about shale oil behavior made it necessary to test its response to low prices.

Historically, the approaches devoted to OPEC's behavior can be categorized into broad groups of models: cartel, dominant firm, target revenue, and some others. In this paper I consider first two groups.

LESSONS OF THE MONOPOLY

The first approach considers OPEC as a cohesive cartel that peruses monopoly strategy and tries to optimize output to maximize its profit. This simple classical framework gives us two valuable insights. First, the decrease of production costs of Saudi Arabia, e.g. via depreciating national currency (Saudi Arabia Real), would stimulate oil production in that country and depress global oil prices. Now Saudi currency reserves decrease impetuously, and if oil prices are still low for longer than a few years, the Kingdom would be forced to ramp up its production.

Second, only Saudi Arabia has a stimulus to cut production as its production volume is on the right from optimum (Qmax - the peak of parabola in Figure 4). All other OPEC members produce less than Saudi Arabia and less than their optimal volumes - their production volumes are on the right of optimum (Qmax). Consequently, they have stimulus to increase supply and that constitutes the classical stability problem of cartel.

According to this approach, the actual Saudi strategy of "market share defense," applied in November 2014, is not the optimal behavior of a monopoly of this size and Saudi Arabia would have benefited from a production rate decrease. However, these theoretical inferences are valid in the case of "games with nature," i.e. without any response to the production change of Saudi Arabia. In the real market, the production drop of the dominant producer results in the oil price hike, which should be a clear signal to the US shale oil producers to boost production. Hence, the dominant firm should take into account this probable response of shale companies when it selects a proper production quantity.

DOMINANT FIRM APPROACH

A historical analysis shows that from 1973 - 1994, Saudi Arabia acted as a dominant producer that determines its own demand as global demand minus supply of other market players (competitive fringe). The dominant producer calculates output maximizing its profit.

I applied this approach for estimation of Saudi decision-making at the three OPEC meetings (November 2014, November 2016, and May 2017). The US shale oil producers are considered as competitive fringe. Production quantities of Saudi Arabia as of the month of the each meeting were compared with calculated optimal production volumes and draw recommendations to increase or decrease production. These production changes were compared with OPEC meetings decisions on production change (Table 1).

Calculations on market parameters of the OPEC meeting as of November 2014 clearly demonstrate that a production growth by Saudi Arabia is more effective than a production cut or freeze. That coincides with the actual strategy of KSA. Moreover, the model prediction to increase production by 0.5 MMb/d came true − in 2016 Saudi's crude oil production averaged to recommended quantity by the model − 10.4 MMb/d. Thus, the market defense strategy in 2014-2016 has fundamental rationale, as it was focused on the profit growth due to market share increase and squeezing the US producers out of the market.

The OPEC decision in November 2016 is opposite to the result of the previous meeting. Supply additions from Iraq and Iran aggravated the glut in the global oil market in 2015-2016 and seemed to force a change in the Saudi strategy at the end of 2016. According to calculations, a decrease of the Saudi production rate by 0.6 MMb/d would have led to a higher oil price and Saudi profit. In the meeting agreement, Saudi Arabia pledged to cut oil production by 0.49 MMb/d starting in January 2017. The whole supply cuts totaled nearly 1.8 MMb/d-1.2 MMb/d by OPEC and the remainder by 11 non-OPEC countries led by Russia. The agreement was set to expire at the end of June 2017.

Saudi Arabia surpassed its promise and, according to secondary OPEC data, cut volume from October 2016 to April 2017 by 0.61 MMb/d, which coincided with the recommendation of the model.

We witnessed oil price growth of 18% just after the OPEC agreement was concluded at the end of November 2016, but over December 2016 - May 2017, price growth moderated to 10% (+$5/bbl) due to factors of supply and demand. Along with sluggish demand in the first part of 2017, the supply of US shale oil ramped with the growth of drilling activity on the back of upbeat oil prices. Libya and Nigeria, which were exempted from the OPEC deal, brought lost oil production quantities back to the market in May-June 2017.

Despite the excellent discipline from OPEC, the production cutbacks did not reach the organization's goal by the May 2017 meeting. Global petroleum inventories did not decrease significantly, and the oil glut had weakened, but not disappeared. In this environment, OPEC decided to extend the production restriction another nine months until March 2018.

This decision is generally in line with the model recommendation (cut minor 0.05 MMb/d). No doubt, some investors-thinking in a similar manner-relied on this additional reduction in production, likely causing the 5% drop in oil prices by the end of the day following the announcement.

The model is rather sensitive to the oil price level. On one hand, if the average oil price in May were $1/bbl higher − $50/bbl, the recommendation to keep quotas would be unambiguous. On the other hand, the prices ranged from $42-46/bbl in June, providing more arguments for a further production cut.

All in all, this simple model with rather rough assumptions correctly predicted the outcomes of all three results of the OPEC meetings in 2014-2017, thus confirming my hypothesis about Saudi Arabia's profit maximization policy. The probability of obtaining this result randomly is relatively small - 12.5%. The next test of the model's reliability will come after OPEC's next regular meeting in March 2018.

SUMMARY

According to the Dominant Firm approach, the strategic decisions of Saudi Arabia concerning oil production volumes made in the three OPEC meetings held in November 2014, November 2016, and May 2017 are rational and based on the profit-maximization policy. The model correctly predicted outcomes of all three meetings under consideration, but it's too early to predict results of the March 2018 meeting because market conditions may change dramatically.

The current low oil price environment urges the model to recommend an additional supply curb. The US production will be more than enough to meet demand growth in 2017-2018 and an additional OPEC production cut would be needed to offset the return of disrupted oil from Libya and Nigeria.

Does the behavior of the other OPEC members matter? Not much, as they don't have spare capacities and can't ramp up production quickly. Using this hypothesis as a yardstick, understanding OPEC decisions becomes more rational and, consequently, predictable?

The next OPEC meeting will be the fourth test for this hypothesis.

ABOUT THE AUTHOR

Dr. Alexander Malanichev (a_malanichev@list.ru) is a visiting professor at the New Economic School in Russia. He specializes in global energy, steel, and related commodity market analysis. He has extensive experience working as a chief economist, chief market strategist, and in other roles in petroleum and steel-making companies. Malanichev graduated from Bauman State Technical University (Russia) as a rocket-science engineer and defended his thesis in mathematical simulation of chemical processes. As a consultant, he worked with senior executives and business-owners providing in-depth market analysis and comprehensive scenarios of business-environment evolvement.