OPEC Faces $750bn Losses From Market Share Strategy

OPEC has made a serious blunder with last November’s decision to defend market share rather than oil prices.

By-Nordine Ait-Laoussine and John Gault*

The current oil market situation has a familiar and disheartening ring to us. In September 1986, we presented an analysis to the Oxford Energy Seminar in which we estimated the high cost of an OPEC decision to pursue market share rather than defend a target price. Our presentation was published in MEES and later included in a collection of articles on the 1986 oil price crisis edited by Robert Mabro1.

Again this past November, OPEC oil ministers faced a similar choice: defend the oil price, which had been declining since June, or defend the OPEC market share, which had been threatened by soaring non-OPEC oil production for several years. No one believed the ministers could do both simultaneously.

Many outside observers and analysts (including ourselves) expected OPEC to pursue its price defense strategy by reducing its ceiling of 30mn b/d, in place since 2011. A cut to something nearer 28.4mn b/d, OPEC’s own projected global requirement for OPEC crude oil in 1Q15, was a reasonable expectation2.

NOVEMBER DECISION

By the week of the November meeting, the average price of the OPEC Basket of crude oils had already declined to about $75/B from $108/B in June. A temporary cut in the ceiling to 28.4mn b/d should have been sufficient to reverse the price slide. Many were surprised that OPEC chose to leave its ceiling unchanged.

Why the meeting made the costly choice to defend market share rather than price is an important question to which we will return later. Meanwhile, we have estimated that the long-run cost to OPEC of its decision ranges from $343bn to as high as $746bn over the period to 2020, depending upon one’s assumptions about how a price defense strategy, had it been adopted, would have been implemented.

Our higher long-run cost estimate (Scenario 1) assumes that a price defense strategy would have cut the OPEC ceiling sufficiently to push the OPEC reference basket price back to $100/B on average (in nominal terms) for each year 2015-20. OPEC would, in this scenario, have had to adjust its ceiling to equal the projected call on OPEC crude for the next few years.

Our lower estimate (Scenario 2) assumes the same cut in the OPEC ceiling would face greater headwinds and would have been able only to stabilize the price slide at $75/B on average for 2015, and to bring the price gradually back to $100/B by 2020. There are many reasons why this slower price recovery is plausible, such as weak OPEC credibility due to past failure to enforce ceilings, unanticipated adjustments of supply and demand data, drawdowns of already high global inventories accumulated over recent years, or unresolved disagreements among member countries on the new price target.

In both our high and low estimates:

> We assumed the call on OPEC crude oil over the remainder of the decade under the price defense strat{{{{NOVEMBER DECISION}}}}egy would follow the trajectory foreseen in the OPEC Secretariat’s World Oil Outlook Reference Case, which assumed an OPEC Basket price of $110/B in nominal terms throughout the 2015-20 period3.

> We compared OPEC’s projected revenue under the price defense strategy with OPEC’s projected revenue under the ongoing market share strategy. The impact of the market share strategy on OPEC revenue is reflected in the IEA’s recent Medium Term Oil Market Report, which assumes a much lower trajectory of oil prices4. The IEA report confirmed our own views on the very limited impact of lower prices on global oil demand and a delayed impact on non-OPEC supply growth.

> We adopted OPEC’s own projections of domestic oil consumption in member countries5 (the IEA Medium Term Outlook makes no equivalent projection).

> We then calculated the difference in OPEC’s projected revenue from petroleum exports under the price defense strategy compared with the projected revenue under the market share strategy, and discounted the difference at 12%. Our estimates ignore revenue losses attributable to natural gas and NGL exports.

These hypothetical price defense scenarios illustrate that a relatively small, credible cut in OPEC output (averaging less than 5% below the current 30mn b/d ceiling on average over the 2015-20 period) would have been sufficient to avoid a much larger (16-29%) loss of revenue now foreseen under the market share strategy.

All of our calculations of OPEC’s comparative loss due to the adoption of the defense of market share strategy treat OPEC as a unit. The loss calculated here is collective, and all member countries bear part of this burden.

HOW DID OPEC MAKE THIS CHOICE? WHAT CAN IT DO NOW?

The decision last November to defend market share was practically imposed by Saudi Arabia who (a) doubted the willingness of other OPEC members to abide by any agreed production cut, and (b) despaired of persuading non-OPEC producers, such as Russia and Mexico, to collaborate on a price defense strategy. Saudi Arabia feared that it alone would bear the entire burden of a price defense strategy, while the benefits would accrue to others.

The decision has yielded a market situation that is far from stable. If OPEC continues producing at present levels, exceeding the global call on OPEC crude oil, further price drops are likely. Some OPEC members such as Iraq (and Iran if sanctions are lifted) will expand output, while global inventories will swell, enhancing price weakness and volatility. OPEC has abandoned its primary raison d’être, namely price stabilization, thus damaging the organization’s long-term credibility.

The challenge facing OPEC is even greater today than it was in 1986, when petroleum derivatives markets were still in their infancy. Today, the volumes of “paper” oil traded on the principal futures exchanges vastly outweigh volumes traded physically. Financial investors now play an enormous role in oil price formation, and their expectations – which govern the magnitude of their holdings of futures contracts and other derivatives – can fluctuate rapidly, as happened last summer and contributed to the price decline. In the absence of a credible OPEC price signal, price volatility will only be exacerbated.

Compounding the challenge to OPEC is the likelihood that governments will seize the opportunity afforded by lower oil prices to increase excise taxes or diminish subsidies. Many governments need to expand revenue to balance budgets, and some will employ taxes on petroleum products also to discourage consumption and reach emissions targets.

Other governments, urged by the IEA and IMF, will reduce or eliminate subsidies to end users of petroleum products. Such modifications to end-user price regimes are most easily implemented when consumers perceive prices to be relatively low. Robert Mabro correctly anticipated such developments following the 1986 oil price collapse6. OPEC members will end up with an even smaller percentage of the end-user value of their principal export than they received prior to adopting the market share strategy – and this will be a permanent shift.

For all of these reasons, it would appear urgent that OPEC reconsider its current strategy and adopt a plan that would reverse the foreseeable revenue loss. How could this come about?

> The initiative must come from OPEC members other than Saudi Arabia. Saudi Arabia has shown no inclination so far to review the strategy adopted last November, and indeed is expressing an unrealistic confidence that oil prices have stabilized and global oil demand growth is accelerating (MEES, 6 March).

> The initiative must persuade Saudi Arabia (and the rest of the world, including financial investors) that other OPEC members are willing to abide by agreed production cuts. This will be difficult given the tendency of non-GCC OPEC members to produce at their respective capacities in the past, regardless of OPEC agreements. Temporary self-restraint will be required particularly from Iran and Iraq, both of whom view themselves as having special historical rights to expand output.

> The initiative should be open to participation by non-OPEC oil exporting countries, but should not be contingent on or even hopeful of such cooperation. Non-OPEC countries have never contributed significantly to OPEC price or revenue stabilization efforts in the past.

> The initiative will lack credibility unless the non-GCC OPEC members have already agreed, before approaching their GCC partners, on how to allocate their share of potential production cuts among themselves.

> Saudi Arabia may welcome the initiative more than recent Saudi statements would suggest. The Kingdom continues to find OPEC useful; otherwise it could have left the organization long ago. The Kingdom has not flooded the market with its own exports, driving prices even lower in a competitive effort to expand market share. The Kingdom clearly understands and appreciates the potential benefits of cooperation.

DÉJÀ VU ALL OVER AGAIN?

While circumstances today are in many ways different from those surrounding the 1986 oil price war, our overall conclusions at that time remain valid:

“We believe that [OPEC] should have never expressed its objective in terms of market share only but rather in terms of overall revenues. As we have seen, the losses already incurred, and those to follow in the future, exceed any imaginable production sacrifice that OPEC would have had to make to defend the price prevailing on the eve of the war7.”

*Nordine Ait-Laoussine and John Gault are energy consultants based in Geneva. Nordine Ait-Laoussine is president of NALCOSA and a former Algerian oil minister. John Gault is Co-Director, Executive Master in International Oil and Gas Leadership, The Graduate Institute, Geneva.

1 Nordine Ait-Laoussine and John Gault, “The 1986 Oil Price War: An Economic Fiasco”, MEES, 6 October 1986, reprinted in Robert Mabro, The 1986 Oil Price Crisis: Economic Effects and Policy Responses, Oxford Institute for Energy Studies, 1988, Chapter 7.

2 OPEC MOMR, 12 November 2014, pp 83, 85.

3 OPEC World Oil Outlook, 6 November 2014, page 32.

4 International Energy Agency, Medium Term Oil Market Report, February 2015, page 12.

5 OPEC World Oil Outlook, 6 November 2014, page 71.

6 Mabro, op cit, pages 6-7.

7 Ait-Laoussine and Gault, MEES, 6 October 1986.