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Game Over: Even If OPEC Wins It Loses

Joe Chidley, Financial Post

OPEC looks like it’s playing to neither win nor lose. The game is over.

It surprised no one, but disappointed many. Last week, the Organization of Petroleum Exporting Countries (OPEC) agreed to extend the production limits it brought in last November for another nine months; the largest non-OPEC producer, Russia, also signed on for the extension. And what did oil prices do? They dropped five per cent to below US$50 per barrel. Go figure.

Clearly, oil traders had hoped for more — as in, deeper cuts to the November production targets. Targets which, by the way, were set following months of record production in Saudi Arabia and Russia. Which obviously limited their net impact.

But when faced with the opportunity to get serious about cutting production in hopes of sustainably higher prices (say, above US$50 a barrel), OPEC blinked. That, too, was nothing new. It blinked last November when it reversed the policy championed by former Saudi oil minister Ali Al-Naimi, who two years previously had sent prices plunging by opening up the taps. Let market forces do their job, was Al-Naimi’s mantra, even as oil dipped under US$30. But he retired last year. And his Saudi successor, Khalid al-Falih, apparently has neither his guts nor his patience.

No doubt, Al-Naimi’s bold U-turn was controversial, and it made life difficult not only for lesser, cash-starved OPEC members like Venezuela, but also for Saudi Arabia itself, whose government revenue and cash reserves took a big hit. But compared with OPEC leadership now and its neither-here-nor-there strategy, Al-Naimi is starting to look like a genius.

Under Al-Naimi’s leadership, Saudi Arabia moved to increase production for one, simple reason: U.S. shale oil producers presented a real challenge to OPEC market share and therefore to its control over prices. The wisdom of that move has only been borne out by the limited return OPEC has seen from the recent production cuts.

Rig counts among North American oil and gas producers continue to grow. In the United States, they’ve increased for 19 straight weeks, according to a report last Friday from oil services company Baker Hughes, and there are now more than twice as many in operation than there were a year ago. The same, by the way, holds true for Canada, where by Baker Hughes’ count the number of rigs has increased by 116 per cent over the past year.

Inventories still seem robust. Back in November, OECD countries had enough commercial crude and other petroleum liquids in combined inventory to last 62 days, according to the U.S. Energy Information Administration (EIA); as of April, they had enough to last 66 days.

Prices remain roughly where they were eight months ago, which makes you wonder where they would be without OPEC’s deal. As it stands, whatever price gains the production limits achieved have benefited not only OPEC producers (marginally), but U.S. shale operators, too. Even during the price collapse, their production dropped by less than anticipated, in part thanks to cheap money that kept them afloat, and in part due to productivity improvements.

According to a recent report from the St. Louis Federal Reserve, first-month production from U.S. shale wells has more than tripled since 2008, thanks to technological and process innovation. Randy Foutch, CEO of Laredo Petroleum, told an industry audience recently that the break-even for operators in the Permian Basin is now US$40 a barrel, and he expects output to grow by more than 25 per cent by 2018.

That highlights the futility OPEC/Russia’s production agreement: if it succeeds, it fails. Every boost to prices gives a boost to shale producers. And every day they stay in business is another day for them to get better at what they do, driving up their cost-efficiency.

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