Shared Production Cuts - The Impossible Dream

Background

As everyone knows and is quick to point out in nearly every oil-production discussion, Saudi Arabia has traditionally been a swing producer. Because of their spare capacity, low-cost oil, and production levels, Saudi Arabia could play a bit with oil supply to keep prices steady.

(As an aside - it's generally thought that OPEC's role was to keep prices high. Or low, depending on what people think this week. However, OPEC's primary role was to stop the rapid fluctuations in oil price that occurred in an unregulated oil market.)

However, Saudi Arabia can only modify the price of oil through supply changes in a small range. We've just undergone a massive fall in price. To give an idea of the scope of the cuts that would be required, in Nov 2014 Russia and OPEC met to talk about shared cuts to bring the price of oil, then around $80/barrel, back up to around $100/barrel. At that time, Russia suggested that Saudi Arabia cut a full seventh of their production just to fix that small (relative to what happened later) price drop.

Obviously, Saudi Arabia would have to make massive cuts to their production levels and, if they managed to raise the price, high-cost producers like the US, Canada, and Russia would simply increase production, dropping the price again.

This happened to Saudi Arabia once before (1980-1986), and it was a disaster for them. They're understandably reluctant to do it all again. So they've repeatedly tired to hammer out an agreement with other major producers, mostly Russia, for shared cuts. Russia has repeatedly refused to co-operate on any production level changes.

Until now.

Brent crude futures pared gains Tuesday following news that Qatar, Saudi Arabia, Russia and Venezuela would lead an effort to freeze output at January levels, dashing hopes of a cut in production.

What's Changed?

This recent semi-agreement is very probably driven by two major factors. The first is that Russia is probably really hurting financially at this point. Practically none of their oil is profitable at $30/barrel, and with the real possibility that the price will go lower, they're probably getting anxious.

The other factor is that Iranian trade sanctions have been lifted, and there's another million barrels of oil a day ready to enter the world markets. That's guaranteed to drive the price lower. Russia would probably like very much for that to not happen.

The Deal

The deal that's been hammered out by Saudi Arabia, Venezuela, Qatar, Russia, and Iraq is fairly obvious in intent, at least according to the reports in the media so far - they want to freeze oil production at January's levels. Here's how that would affect each nation, including Iran:

Saudi Arabia - already producing near maximum capacity, so a production freeze has no effect on them at all.

Venezuela - already producing at maximum capacity, so a production freeze has no effect on them at all.

Qatar - production in serious decline for years now, so a production freeze has no effect on them at all.

Russia - already producing at maximum capacity, so a production freeze has no effect on them at all.

Iraq - has doubled their production in the last ten years, and may be nearing maximum capacity. Even if not, they're in a good position production-wise, so not hurt too badly by a production freeze.

Iran - producing at 1 mmbpd below their pre-sanction levels, so a freeze would prevent them from recovering their full production capacity.

Of course, Iran has said "no" to this arrangement. It's not clear from reports if any concessions were made to Iran due to its special circumstances, but just on the face of the deal as reported, there's zero incentive for them to agree to it.

Possible Outcomes

The fact that any kind of deal, even a bad one, has been worked out with Russia indicates the level of desperation these producers must be feeling. Trying to stop Iranian oil from entering the market is surely a beginning step, and intended to stop further collapses in price rather than to raise the price.

Shared production cuts, as opposed to a proposed freeze, between these major producers is, in my opinion, unlikely at this time. If they occurred, and if they were successful in raising the price of oil (not at all certain, see below), then all that would happen is that US and Canadian production would increase, again driving the price down.

This is probably the biggest obstacle to cuts by major producers. There's another one, however, although less certain.

Prices have largely collapsed due to poor economic conditions. Industrial activity is slowing, trade is slowing, global economic growth is slowing, and possibly even flat, depending on how inaccurate China's economic figures are. Oil prices can't rise without the need for more oil (increasing industrial activity) and the ability to pay sustained higher oil prices. Neither of those conditions are likely with the poor economic situation the world is in.

So my own suspicion is that even if there's a miracle and shared cuts occur, they won't raise prices as high as they were, and probably not in any sustained fashion. Barring, of course, some kind of major state economic intervention in the markets.

Lastly, one interesting factoid - total global liquid fuel production peaked in August of 2015, when oil was selling for $50/barrel. Since then, production has decline by a million barrels a day, and the price of oil is now $30/barrel. Something to keep in mind when assuming that a decreased supply automatically means a price increase.

How Oil Affects Economic Growth Over Time

Dispelling some myths about oil

I may as well start this blog off by clearing up a surprisingly large number of myths, assumptions, and untruths about the current situation with the price of oil.

I'm not into conspiracy theories, preferring to attribute to incompetence rather than malice. I suppose that the reason there's so much misinformation in the media at this point is because the behavior of the price of oil is so confounding. People generally like simple easy-to-understand reasons for things or good-guy bad-guy morality plays. Pointing a finger at oil companies, the US, Saudi Arabia, or aliens feels better than the thought that no one is in ultimate control, that it's all chaotic.

So here's most of the stuff that I've seen in the media or heard people claim as common knowledge. I've provided source links or graphics for the debunking of most of these.

Saudi Arabia and OPEC

Saudi Arabia didn't cause the drop in oil price. It occurred due to a number of depressing predictions about global economic growth in 2014.

 

Saudi Arabia doesn't set the price of oil, it's set by the global commodities market through bidding.

OPEC is not flooding the world oil market. Their export levels are relatively stable, with the recent increase in production coming from Iraq, not Saudi Arabia.

Saudi Arabia hasn't "opened the taps" and is flooding the world with oil. While their production increased by about 5% for a portion of 2015, the extra was for domestic use. Their export levels have been relatively fixed for years now.

OPEC doesn't produce most of the world's oil. They only produce about 40% of the world's crude oil.

Source - Art Berman, The Petroleum Truth Report

Saudi Arabia does not want low-priced oil. They've had an offer on the table for at least a year with other major producers for shared cuts in order to raise prices. The other major producers (mostly Russia and Iraq) have refused, hoping that Saudi Arabia would make the cuts by themselves.

Saudi Arabia has historically acted as a swing producer for OPEC due to their high production levels and spare capacity. This means that they could raise or cut production to make up for small to medium variances in production or demand in order to stabilize the price of oil. However, they've never been able to successfully control price swings this large with production changes. Saudi Arabia once tried to keep the price of oil high through major production cuts once before, in 1980-1986. They eventually cut an astonishing two thirds of their production, but all that happened was that other producers increased their production to take advantage of the higher price, which drove the price down again.

Saudi Arabia is defending market share, not pursuing greater market share. Greater market share only makes sense when you can produce more product to make more money. They can't, they're near their maximum output. If the world keeps needing more and more oil, that new oil has to come from some source other than Saudi Arabia and the rest of OPEC. It makes no sense to say they're trying to get rid of US tight oil.

North American Tight Oil and Bitumen Industry

(NOTE - while the correct term for the US oil recently being produced in higher quantities is "light tight oil", there's sufficient confusion about the term in the media that I refer to it here as "tight shale oil", even though the term is technically incorrect)

Overall, tight shale is not profitable at current prices (around $30/barrel). There are undoubtedly sweet spots in which oil is cheap to extract, but the overall costs (including upfront capital costs) put the industry average break-even price at  $65-$70.

In general, tight shale and bitumen were not made economically viable through technical innovation. They were made economically viable through high oil prices.

Fracking (hydraulic fracturing) and directional drilling are not new technological breakthroughs. Fracking has been around since 1949 while directional drilling was first accomplished in the 1930s.

Tight shale production is not done mostly through software innovations. Fracking requires an extra large investment of energy and materials over conventional oil wells, which accounts for its higher break-even cost. 

The tight shale and bitumen industry are not still producing lots of oil because of higher efficiency and productivity. They're still producing oil from completed wells because they have no choice: investment and credit are drying up, and many have debt loads to service. Aside from hedges, the majority are selling oil below the cost it took to produce it.

The US is not energy self-sufficient or a net oil exporter. Far from it, the US imports between 6 and 7 million barrels of oil a day. 

Global Oil Production

We aren't experiencing unusually high levels of new oil. While North America has produced virtually all of the new oil added to global production in the last ten years, production elsewhere has been declining.

Oil companies weren't experiencing significantly higher profits in ratio to earnings when oil prices were higher. Capital expenditures in the last decade have expanded enormously as economical deposits of oil became more difficult to find . In the last decade, the oil majors increased spending five times to produce the same amount of oil.

The world is not producing 94 million barrels of crude oil a day (mmbpd). This figure is often used mistakenly, but it actually represents total liquid fuel production. That includes biofuels, natural gas liquids, propane, and other fuels. Crude oil is petroleum, or oil found in the ground. The world is currently producing somewhere near 80 mmbpd of crude oil and condensates (a gasoline-like hydrocarbon often associated with oil).

Alternative Energy

Oil producers are not losing market share to alternatives like wind and solar. Despite recent jumps in installed capacity, Wind and solar combined produce around just 1.5%-2% of world energy, far below levels that are a competitive threat to oil. 

Alternatives like solar and wind don't directly compete with oil. They produce electricity, and very little oil is used to produce electricity.

Electric vehicles are not producing much of a measurable decline in oil use. The numbers on the road at this time are too small to make much of an impact.

Oil producers are not divesting themselves from oil because they're worried about alternatives sometime in the future. Oil is a major energy source, it's crucial to the world's economy. If alternatives ever start taking business away from oil (which isn't happening, see above points), then there would be a business case for getting out of oil. Until then, it's just business as usual.

The Economy

Cheap oil does not provide an automatic overall benefit to the economy in the current case. The vast majority of oil being sold today (80%, or 60 mmbpd) is being sold at prices below the cost to produce it (including capital costs). Overall, US tight shale oil sold at $30/barrel loses about $35-$40 per barrel. At 5 million barrels a day, that's an eventual net loss of up to 2 billion dollars a day to US companies, and, ultimately, the US economy.

A lowered supply of something does not automatically mean that the price increases. In oil's case, the price also requires increasing need for the commodity and sufficient wealth to afford the higher prices. Neither of those are present when global economic growth is stagnant or declining.

A "glut" of oil doesn't necessarily mean that we have more oil then usual. In this case, it means that we have more oil then we need. Global crude oil production isn't unusually high at the moment (see graph in Global Oil Production).

Peak Oil

Peak oil is NOT about running out of oil. It's about reaching a point in time when the amount of economically viable oil being produced reaches a maximum rate, and then declines thereafter.

The price of oil can't simply revert to historical norms without restricting oil production in the long term. Oil used to be cheaper to obtain in the past, so a lower price still allowed growing production. That isn't the case any longer, so a lower price will eventually mean lower production levels.

Source - Our Finite World

(NOTE - an earlier version of this post by me appeared on Reddit)