World Crude Oil Market Bigger Than OPEC

Posted by: : Paul Ebeling Posted on: October 18, 2014

World Crude Oil Market Bigger Than OPEC

Crude Oil prices above 100 bbl are unsustainable because they lead to too much new supply and
too much demand destruction
There is nothing remotely surprising about the sharp fall in Crude Oil prices over the last 4
months, except perhaps the timing.
The fundamental forces driving prices lower (rising supply outside OPEC from shale and
sluggish demand growth as result of conservation and substitution) have been clearly visible for
at least 2 yrs.
If the shale oil revolution can be sustained in the United States, and successfully exported to
other countries, some combination of OPEC production cuts or lower oil prices to encourage
demand and forestall more investment, will be inevitable by 2015-16, John Kemp (Reuters)
wrote last year.
The massive rise in prices means Saudi Arabia will face intense competition from shale, he
wrote earlier, in Y 2012.
Compounding the problem, projected oil demand is now expected to grow much more slowly
than a few years ago as a result of conservation measures.
But it did not require a crystal ball to see that prices above 100 bbl were unsustainable.
Inexorable increases in shale oil production have been evident in the reports published every
month by North Dakotas Department of Mineral Resources and the US Energy Information
Administration (EIA).
On the demand side, consumption of refined products in the United States is still more than 2-M
BPD lower than it was in Y 2005, and the drop is more like 3-4-M bbls if population and output
growth are taken into account.
James Hamilton, veteran Crude Oil expert at the University of California, calculated Crude Oil
demand across all the advanced economies is 8-M BPD lower than it would have been if it had
continued growing on the previous trend.
Prices above 100 bbl are unsustainable because they encourage too much new supply and
incentivise too much demand destruction.

For the last 3 yrs, the incipient imbalance between supply and demand was masked by a series of
1-off supply interruptions which removed enough Crude Oil from the market to offset rising
shale Oil output.
US sanctions on Iran coupled with civil wars and unrest in Libya, South Sudan, Syria and Iraq all
helped conceal the extent to which the market was oversupplied.
As the EIA points out, production losses as a result of these interruptions has broadly matched
the rise in US shale output.
The timing of the correction (benchmark Brent prices are down more than 25% since June) was
always uncertain.
Mr. Kemp thought it would come a little later, starting in Y 2015, when the pressure from rising
rival supplies and stagnating demand would really squeeze market share for Saudi Arabia and the
rest of OPEC.
But the fact that the decline was triggered by resurgent Crude Oil exports from Libya, which rose
from 200,000 BPD in June to 900,000 BPD at the end of September, according to the EIA,
should come as no surprise to the market.
Since it was only supply interruptions that had supported the market above 100 bbl for the last 23 yrs, any resumption was bound to trigger a sharp correction, as the EIA notes.
Therefore it is logical for Saudi Arabia, and other members of OPEC, to resist calls for
production cuts to reverse the slide in prices.
Even if OPEC could cut production enough to push prices back above 100 bbl, it would just
encourage more shale Oil drilling and the continued stagnation of demand, making the problem
even worse.
Saudi Arabia, and OPEC, would be sacrificing market share to support prices at an artificially
high level, and within a few months even deeper cuts would become necessary.
The lesson from the 1980s, when Saudi exports shrank from 10-M BPD in Y 1980 to less than
3-M BPD in Y 1985, and OPECs combined production halved from 30 to 16-M, is that no
amount of cutting can support prices when supply outside OPEC is growing strongly and
demand is weak.
Recall that the early 1980s, OPEC was set back by rising output from the Soviet Union, China,
Alaska and the North Sea, as well as substantial conservation measures and switching to cheaper
fuels like Nat Gas and Nuclear, all of which were a delayed response to the Crude Oil shocks in
Ys 1973 and 1979.

In the early 2010s, OPEC was caught off guard by rising production from shale Oil and a
substantial conservation drive, especially in the United States, which are the lagged response to
4Xing of Crude Oil prices between Ys 2002 and 2012.
The parallels between the 2 periods are very close, confirming that if history does not exactly
repeat itself, it come close.
The director of market reporting for Platts remind us who follow the petroleum markts that the
best cure for high prices is higher prices. But the reverse is true too. The best cure for low prices
is lower prices.
The events of the early 1980s were traumatic for Saudi Arabia, which was hit by a combination
of falling prices and shrinking export volumes, the worst possible combination.
To prop up the market, the Saudis reached out to Great Britain for help.
Prime Minister Margaret Thatchers free-market government briefly put pressure on North Sea
Crude Oil producers not to cut their prices, as a Royal Dutch Shell (NYSE:RDS-A) insider
recalled.
When Norway refused to follow suit, and the strategy failed, and other OPEC members
continued to cheat on their quotas, the Saudis stopped cutting output to support prices in Y 1985
and switched to netback pricing to regain their lost market share, in effect guaranteeing
refiners a set margin in exchange for buying Saudi Crude Oil.
Netbacking and the resulting volume warfare sent prices sharply lower, at 1 point dipping briefly
below 10 bbl, that was too painful, and the cartel found new discipline, with members agreeing
new quotas and adhering to them, more or less, in Y 1986.
It was not quotas, or renewed cartel discipline, that ended the crisis.
Both inflation-adjusted prices and OPECs market share remained much lower throughout the
late 1980s and the 1990s than they had been before the crisis. Saudis Arabias budget remained
in deficit for almost 20 yrs, as a result of the drop in revenue.
Then a long period of low prices gradually restored balance between supply and demand.
Low prices discouraged investment in supply, no major new Oil formations were developed after
Y 1985 until shale Oil came along 20 yrs later. Tens of thousands of highly skilled petroleum
geologists and engineers were laid off in the 1990s in a bloodbath of cost-cutting, Houston, TX
was almost a ghost town.
Consumers grew complacent.

Crude Oil never recaptured its former market share in heating and power generation. But in the
transport market, cars became larger, heavier and more powerful as consumers forget the pain of
Ys 1973 and 1979.
In the United States, new cars and light trucks achieved 22 mpg in Y 1987, up from 15.9 mpg in
Y 1979, but by Y 2004, that had slipped to 19.3 mpg, according to the EPA (Environmental
Protection Agency).
The average weight of new vehicles climbed from 3,221 lbs in Y 1987 to 4,127 lbs in Y 2011.
Engine power doubled from 118 hp to 230 hp.
It took almost 20 yrs, from Y 1986 to Y 2003, for all the demand lost to be bought back and
spare production capacity inherited from the early 1980s to be used up, but it when it occured,
the conditions for the next price rise were in place.
This situation is less serious than the 1 that confronted OPEC in the 1980s and 1990s.
Crude Oil prices have been unsustainably high, but the margin of overvaluation is smaller, and
the intrupution or war factor is diminished . There is excess supply, but much of it is incipient
rather than realised. The market should rebalance far more quickly than after Y 1986.
The longer that the imbalance between supply and demand persists, the worse it will become and
the deeper and longer the correction that will be needed.
So, the only reasonable strategy for Saudi Arabia, and OPEC, is to focus on market share and
allow prices to decline to the point at which they slow the growth in non-OPEC production
Crude Oil output and lessen the push for more energy efficiency as prices fall both at the well
head, and the pump.
Stay tuned