Moisés Naím / World Energy & Oil

The Arab spring and Libyan civil war triggered a significant increase in oil prices, which remained at an average of nearly $100 per barrel during this period of political turmoil, roughly between 2011 and 2014. High prices allowed shale oil producers in the U.S. to increase their activity, which helped the country to nearly double its total production, from some 5.3 million barrels per day (bpd) in 2011 to almost 10 million bpd in 2014, and to reduce oil imports by about two million bpd during the same period. This was not good news for OPEC oil producers. Not only was the U.S. decreasing its dependence on OPEC oil but its booming oil production at home fed a global oil glut, which created strong downward pressures on prices. The economic slowdown of big oil consumers such as China and an anemic global economy also added to the weakening of oil prices. Increasing concerns about this turn of events led OPEC to deemphasize its goal of “protecting” oil prices and favor instead a strategy designed to protect and, hopefully, increase the cartel’s market share. To achieve this goal OPEC decided not to react to declining oil prices and to keep production levels high, a move led by Saudi Arabia. The target of this strategy was the U.S. shale oil production, which would for the most part become uneconomical at prices below $50 per barrel. This strategy worked for almost two years, between 2014 and 2016—U.S. shale oil production dropped by almost one million barrels per day during this period. But this approach proved unsustainable as OPEC members started to feel the pinch. In Saudi Arabia, for example, fiscal deficits in 2016 soared to 12 percent of GDP, oil revenues in 2015 dropped to half of those in 2011, imports were significantly curtailed and unemployment rose to about 12 percent. By the end of 2016, Saudi debt had risen to 15 percent of GDP and was projected to reach 23 percent of GDP by 2018.

A turnabout
In general, OPEC members suffered a large and painful reduction in their income from oil exports: it plummeted from $753 billion in 2014 down to an estimated $341 billion in 2016. This proved to be too much to swallow for Saudi Arabia, and the government decided to change course and seek higher prices through significant reductions of its production levels. Following this lead, in December 2016 OPEC decided to cut its overall oil output by about 1.2 million barrels per day, with Saudi Arabia absorbing almost half of the production cut. Iran, Nigeria and Libya were exempted from the cuts, while volume reductions assigned to Venezuela and Ecuador were very modest, of no consequence in the global context. Oil production cuts were also promised by non- OPEC nations, particularly Russia, Azerbaijan and Mexico, bringing the intended decrease in global oil supply to about 1.8 million barrels per day. OPEC estimated that with this volume of production cuts the price of oil would climb to about $60 per barrel by early 2017. Indeed, as soon as the OPEC announcement was made, oil prices increased between 10 and 15 percent. Shares of oil companies rose, lifting the Standard and Poor index to a new record high. Shares in the biggest U.S. shale producers also rose between 8-10 percent, as this sector could smell victory over Saudi Arabia in what they had considered a price war.

Five critical factors
By early 2017, oil prices still are in the range of $53-54 per barrel. This would suggest that the initial psychological impact of the production cut on global markets has been weaker than on previous occasions. The dominant sentiment in the market is not that we live in a world where hydrocarbons are scarce but rather that supply is abundant and growing while demand continues to be contained by a weak global economy and the surprisingly rapid inroads made by renewables like wind and solar. Higher oil prices are also held back by several other factors.

1 | One is high inventories. Despite some declines of their levels in late 2016, global inventories stand at 5.7 billion barrels, a high volume that weighs heavily on price dynamics.

2 | A second factor that conspires against higher prices is the fast supply response of the United States producers to higher prices. U.S. oil production has risen more than 6 percent since mid-2016 and shale oil output is back to late 2014 levels. Baker Hughes, an oil services company, reports that since mid- 2016 U.S., drilling units in operation experienced their largest increase of the last four years.

3 | A third factor is an old and unsolved OPEC challenge: how to maintain price discipline among its members. According to Saudi Arabia’s Energy Minister OPEC’s oil cuts are taking place according to plan. Yet, previous oil cuts have revealed frequent cases of cheating among the members of the organization. This time Iraq could be one of the weakest links in the chain, due to the poor control they exert over oil production in the Kurdish zone. Since OPEC producers such as Iran, Libya and Nigeria are exempted from the agreement, proper monitoring of compliance to the cuts will be difficult.

4 | A fourth factor is Russia, the world’s second largest oil producer. According to its Energy Minister their aim is long-term market stability rather than high oil prices. He also noted that Russia’s budget for 2017 is based on oil selling at $40 per barrel. High oil prices would help, he said, but “do not matter” for Russia as much as for cash strapped OPEC members. Moreover, Finance Minister Anton Siluanov has stated that Russia’s fiscal situation should be in balance as long as oil prices remained in the $40-45 range for the next three years. If anything, Russian priorities would seem to favor an increase in oil production. And, of course, the evolution of the economic sanctions that the United States and Europe have imposed on Russia as a result of its invasion of Crimea and its intervention in Ukraine will also bear on the impact of Russian oil on world prices.

5 | Finally, we have the Trump factor. The new U.S. president is bullish on increasing domestic oil production and this will have a downward impact on prices. OPEC oil cuts will most probably generate, in the medium term, an oil price increase, one likely to be weaker than expected. The U.S. Energy Information Administration (U.S. E.I.A.) predicts that oil prices will increase to only about $55-56 per barrel during the next two years, as U.S. production increases by about 500,000 barrels, partially offsetting OPEC’s oil cuts. In the meantime some of the more financially pressured OPEC members could be forced to increase their production, further weakening the effect of OPEC’s measures. The presence of the U.S. as a non- OPEC swing producer seems to have introduced an important change in what used to be an OPEC dominated oil price game.

The Nash equilibrium
Such a new balance promotes what game theorists refer to as a Nash equilibrium. There will be no incentives for OPEC to cut oil production any further as long as the U.S. keeps increasing its own oil production to compensate for OPEC’s cut. Of course, there is always the possibility that such a delicate balance could be disturbed by unilateral actions from one or more large oil producers with an urgent need for more oil revenues at any cost. But perhaps the most salient conclusion is that recent oil market dynamics reaffirm the reality that OPEC is not what it used to be. Its ability to influence oil prices has been waning for decades and the very limited impact of its recent attempts to influence the market confirm that this trend has not changed. A second important message is that while structural factors point to a protracted period of relatively low oil prices, this market is prone to sudden price surges caused by geopolitical accidents. And 2017 started with a heightened sense that the list of possible accidents that can drastically disrupt oil markets is longer and more ominous than it has been for a while.