Sex and Technology: The Market Encroaches on OPEC
Speaking to a large audience in Houston, Texas, in February 2016, then–Saudi oil minister Ali al-Naimi disappointed those who were betting on a Saudi intervention to address low oil prices. “Let markets work,” he urged the crowd. There is no need for “meddling,” as the market would eventually rebalance supply and demand and lift the price of oil to more sustainable levels, he assured journalists jotting down his every word. Although sounding less sanguine about the future, al-Naimi’s successor underscored the same message to his colleagues at an OPEC meeting just four months later. Khalid al-Falih, the man long in charge of Saudi Aramco, the Saudi oil company, was new to an expanded ministerial post that included not just oil, but also other forms of energy, industry, and minerals. He told a small gaggle of reporters visiting him in his penthouse hotel suite in Vienna in 2016 that oil producers should “let the market forces continue to seek and find that equilibrium price between supply and demand.”
For nearly two years, Saudi Arabia and OPEC left the rebalancing of their most valuable commodity to market forces, before attempting to reassert themselves through a new OPEC deal in November 2016. An American economics student may see nothing newsworthy about letting the market balance supply and demand. Yet, for almost the entire history of oil markets, there has been a powerful group that held sway over global supply. OPEC is but one institution in an infamous line of mechanisms created to ensure that the market alone did not balance supply and demand. Institutions representing corporate or national interests have almost always exercised some control over the price of oil.
The first institution to wield such power over price was John D. Rockefeller’s Standard Oil, which at the turn of the twentieth century had such influence over the distribution infrastructure in the United States that it effectively controlled the price of oil. Certainly, this was the perception of the readers of one of the most popular articles of all time in The Atlantic. In 1881, readers gobbled up seven straight printings of the magazine to read “Monopoly on the March,” an article calling for the end of Standard Oil.
Twenty years later, the Justice Department broke Standard Oil into thirty-four companies. Yet, before long, a new entity assumed a variant of the same role. The Texas Railroad Commission was essentially the world’s first oil cartel. In fact, OPEC later modeled itself on the organization. Initially formed by Texas governor James “Big Jim” Hogg to regulate the much-loathed railroads, the commission eventually assumed duties to regulate oil production in Texas, one of the epicenters of global production at the time. When, near the start of the Great Depression in the early 1930s, the newly discovered East Texas field gushed forth so much new oil that the national price collapsed from $1.27 a barrel to 65 cents a barrel within two years, the commission instituted a quota system limiting the level at which every oil well in Texas could produce in an effort to bolster price. Rampant cheating was so persistent that Governor Ross Sterling declared martial law on August 15, 1931, and deployed the National Guard to shut down wells. Yet, despite these difficulties, the commission held huge sway over the price of oil for decades.
As oil production became increasingly global, a new grouping called the “Seven Sisters” and made up of the world’s largest oil companies, became the dominant force influencing the price of oil. The idea of a cartel among them was born in secret on August 28, 1928, at an appropriately secluded castle in the Scottish Highlands. From the 1940s until OPEC was formed in 1960 and the nationalization of oil companies began, these Seven Sisters divided the market among themselves and sustained uncompetitive and high prices by restraining production. In 1953, they controlled almost 90 percent of the world’s oil production. Even a dozen years after the establishment of OPEC, the Seven Sisters still held sway over 70 percent of global production. It would take multiple nationalizations to erode their power.
For the last half century or so, OPEC has played this role of managing the market. OPEC has not sought to set the price of oil directly as many American politicians would have their constituents believe. Instead, OPEC—like the Texas Railroad Commission—has influenced price indirectly, by calibrating global supply through its own contributions to the market. In essence, because there is one global market for oil, OPEC has sought to control how much oil is in that market, sometimes adding to supply and sometimes subtracting from it in order to reach the price desired by its members.
The cartel’s ability to play this role in the past has relied heavily on two factors. First is cohesion within the cartel and the willingness of its members to cooperate. When this cohesion has been at its highest, OPEC has been most effective in influencing the market. Of even greater importance, however, has been the willingness of OPEC, and Saudi Arabia in particular, to be the “swing producer.” Unlike nearly all other producers, the kingdom has maintained significant spare capacity. Despite being expensive to develop and maintain, Saudi Arabia only uses this excess oil production on occasion. But its existence has allowed Riyadh on very short notice to “swing” its production in either direction as necessary to maintain the price of oil at a certain level or within a price band.
There are good reasons to question OPEC’s continued ability to play this dominant role in oil markets. The first relates to political solidarity within OPEC. Trust—and therefore cohesion—among OPEC members has been at rock bottom in recent years. Hostility between OPEC members Iran and Saudi Arabia animates the region. The competition between the two regional powers skates just beneath the surface of the Syrian civil war and is even more overt in Yemen. The sectarian conflict between majority Shi’a Iran and Sunni Saudi Arabia burst into full daylight in early 2016 after an Iranian crowd burned the Saudi embassy in Tehran following Saudi Arabia’s execution of a dissident Saudi Shi’a cleric. On top of what can generously be called a “trust deficit” are the tenuous economic circumstances of many OPEC members from Venezuela to Iraq.
Nevertheless, the OPEC deal struck at the end of 2016 surprised the naysayers. For the first time since 2008, OPEC agreed to production cuts. Ten of OPEC’s members—and eleven non-OPEC countries—collectively agreed to decrease output to the tune of 1.8 mnb/d, or not quite 2 percent of global production at the time. Increasing prices and revenue finally appeared more urgent than advancing narrower political objectives; in 2016, OPEC countries had only earned $341 billion from oil exports, compared to a record $920 billion in 2012. The 20 percent boost that news of the planned supply cuts generated provided much-needed relief to cash-strapped oil producers; equally important, the deal hastened the gradual movement toward balancing supply and demand in the market, after years of burgeoning inventories that held down prices. To many, this agreement augured a new chapter in cooperation among OPEC countries and between them and others outside the cartel, most notably Russia. Oil ministers from Saudi Arabia to Venezuela declared the agreement “historic,” appearing almost visibly relieved that OPEC had been resuscitated from its stupor.
However, several realities throw cold water on the idea of a resurgence of OPEC. First, the political compromises required to cement the agreement may end up undermining it. Despite dragging its feet, Iraq agreed to limit production for the first time since the 1991 Gulf War. Yet that achievement was outweighed by the number of exceptions given to others. Iran successfully argued that as it had just been relieved of international sanctions on its energy industry, it deserved the right to increase its production, rather than the opposite. Libya and Nigeria were similarly successful in negotiating exemptions from output decreases, given the civil conflict occurring in each place. At a minimum, any production boosts from these three countries work against the cuts made by other OPEC members hoping to balance the global market and put a floor under prices more quickly. In some scenarios, however, oil supply growth from Iran, Libya, and Nigeria could virtually annul the larger cuts. In the first month of the agreement, these three countries collectively brought supplies online equal to one-third of the cuts made
by other OPEC members.
Second, tight oil continues to challenge OPEC’s way of doing business. As described in the previous chapter, the new way in which tight oil can respond to price more quickly than conventional resources has undermined the incentive of Saudi Arabia and others to cut production to bolster price. Put succinctly by Abdalla El-Badri in early 2016 when he was still the secretary general of OPEC, “Shale oil in the United States . . . I don’t know how we [OPEC and shale] are going to live together.” Remember al-Naimi’s original logic: it did not make sense for Saudi Arabia to cut production in the face of falling prices in 2014 because tight oil producers would respond to higher prices by increasing production and taking Saudi Arabia’s relinquished market share. Why the change?
The OPEC agreement did not annul these tight oil realities. Rather, it suggested two factors were at play. The first was the seriousness of the cash flow crisis experienced by Saudi Arabia and other OPEC producers. They must have valued increased revenues in the very short term more than they feared losses in market share over some unspecified period when tight oil would return to the market. Second, the Saudis and others likely felt that they had gathered important information on how responsive tight oil was to price changes over the two years that had elapsed since the initial price collapse. Tight oil had proved more sluggish in responding to price drops than expected. Rather than quickly curtailing production when faced with falling prices, U.S. tight oil production remained resilient. The Saudis, and others, may have inferred from this track record that, while tight oil production was much more responsive to price than conventional oil production, there was enough of a lag between price changes and production adjustments that OPEC producers could expect to reap the gains of an oil price boost for a half a year or even longer. While not ideal, reaping some gains in the short term may have been viewed as too attractive to resist.
Yet even before OPEC and other producers could translate their agreement into action, tight oil began to respond positively to the tightening of the oil market and slightly firmer prices. From September 2016—when rumors of an OPEC deal first emerged—until June 2017, tight oil production in the United States added more than 800,000 barrels a day. The adherents to the 2016 deal may not like what they see in the subsequent months as tight oil production grows robustly. Technological advances made in the past two years—such as the ability to drill more wells from one platform—mean more tight oil will be produced at lower prices. John B. Hess, the CEO of Hess Corporation, put it well when he told me in the last days of 2016, “the shale you needed a price of $60 to produce two years ago now makes sense to bring on line at $50.” Roger Diwan, an energy market expert, made a similar point when in March 2017, at the margins of one of the largest energy conferences in the world, he told me that capital efficiency has increased so much since the price collapse that one dollar of expenditure today will yield two and a half times the oil that it would have at the end of 2014.
In short, while the November 2016 deal offers oil producers some immediate financial relief, it is hardly grounds to claim that OPEC has roared back to center stage. At best, OPEC has proven it is not yet in the grave and has been forced to share the stage with more robust co-stars: tight oil and the market itself. In the closing days of 2014, Nick Butler, a former energy advisor to British prime minister Gordon Brown and longtime energy guru, predicted that “sex and technology” will shape the oil market for the foreseeable future. It is true that sex—as a proxy for population growth—has always had a strong impact on demand, and technology has influenced both supply and demand. This will be more true going forward than it has been for many decades, the efforts of OPEC to reassert itself notwithstanding. In this new world of energy abundance, the fundamentals of supply and demand will have as much or more influence than any cartel in determining the price of oil.
The Next Saudi Arabia?
Given oil’s long history of having a mediator between it and the market, one might ask if another entity will emerge now that OPEC is weakened. Some see the United States as a potential successor. Experts from former Federal Reserve Board chairman Alan Greenspan to ConocoPhillips CEO Ryan Lance have suggested that American tight oil makes the United States well positioned to be the swing supplier. The ability of tight oil to adjust relatively quickly when prices rise and fall creates this new possibility. But can U.S. tight oil really substitute for OPEC or Saudi Arabia in the three main roles these entities have played over the past decades?
A great deal of Saudi Arabia’s past strategic heft arose from the kingdom’s ability to play its first role: stepping in and adding oil to global markets in advance of, or immediately after, a destabilizing geopolitical event. For instance, at the behest of the United States, Saudi Arabia agreed to increase production in advance of both the first Gulf War and the 2003 invasion of Iraq. Washington and Riyadh knew that the military conflict risked the removal of Iraq’s oil from the global market, potentially causing a dramatic price spike. More recently, in 2012, when the Obama administration was seeking the cooperation of China, India, and others in curtailing Iran’s oil exports, Saudi Arabia’s willingness to increase its production was one factor that allayed nervousness about the impact turning on Tehran could have on oil prices. In all these cases, Saudi Arabia’s willingness and ability to turn up the taps within days or in advance of geopolitical turmoil helped keep oil markets relatively calm.
American tight oil has no ability to assume this critical role. The expansion or curtailment of American tight oil flows are almost entirely dependent on price signals. There is no U.S. government entity—no “national” oil company—that can decide to unleash or constrain the country’s tight oil production. The government can, of course, influence production through taxes, regulation, and permits, but such tools are hardly designed to affect short-term output. As a result, U.S. tight oil will respond to the price jump created by a geopolitical crisis; it is in no position to preempt a price increase or respond to a political imperative.
The second role OPEC has played with varying degrees of success is dampening volatility in the oil markets. Those licking their chops for the end of OPEC have generally overlooked this contribution. Many economists view volatility in the price of energy as more damaging to economies than high prices; three researchers from Oxford University published a study in early 2014 on the volatility of crude oil prices, calling it “a fundamental barrier to stability and hence growth.” Surveys of hundreds of senior financial executives found that more than “an astonishing” three-quarters of them would make some sacrifice in overall value of an investment in order to avoid volatile earnings. We might therefore postulate that given a choice between stable oil prices at $70 a barrel versus a constantly fluctuating price between $70 and $100, many oil-producing companies and governments would opt for the first. Volatility complicates decision-making for energy companies looking to make billion-dollar investments, some of which may be profitable at $70 oil, but not at $50 oil. Volatility in energy prices also frustrates the creation of realistic budgets for both producing and consuming governments. And it further complicates the task of governments that rely on energy taxes to fuel their spending, or that provide energy subsidies to their populations. Even individual consumers would allocate their money more sensibly with more certainty about fuel prices and fewer surprises at the pump.
OPEC’s calibration of supply has often been geared to temper this price volatility. Rather than every shift in demand or every supply-contracting crisis forcing a change in the price of oil as a way of sending a signal to the market, OPEC—or simply Saudi Arabia—would adjust production at the margins to minimize the ups and downs in price. Although not always successful, the cartel sought to understand and anticipate trends in oil markets enough to keep prices steady.
Again, tight oil cannot be the antidote to oil price volatility because changes in tight oil production will only emerge as a result of a change in price. In the absence of an overseer, each of America’s hund
reds of individual producers will be making its own calculations about when to stop and start, based on the signals sent by the market. And although tight oil can be brought to market relatively quickly when compared to conventional oil, U.S. tight oil is still a laggard when compared to the speed at which OPEC or Saudi Arabia can tap into their spare capacity. “The big dogs, the Saudis, could snap their fingers and make that [bringing more oil to market] happen by tomorrow,” said Mike Wittner, head of oil research at Société Générale in New York. “Here [in the United States], you have a whole sector of a couple hundred companies doing what they do and looking out for their own self-interests, and the whole thing takes a long time.” At a minimum, companies working in the United States and looking to ramp up production will first need to recontract for drilling rigs, rehire employees who were let go, and reorder fracking fluids—potentially adding weeks or months to the timeline between the decision to produce and actual output increase. In addition, companies will need to find adequate financing, which may prove to be more difficult than it was in the first frenzy surrounding fracking. If anything, tight oil will increase volatility in price by shortening the response time between price change and production adjustment of conventional oil. Yet, however shorter this response time is, it will inevitably remain longer than that of OPEC, given the ability of several OPEC governments to swiftly increase production.
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