The changing dynamics of the global oil market

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On Thursday, Opec will hold its most crucial meeting since 2008; back then the cartel announced deep production cuts to counteract plummeting oil prices in the wake of the financial crisis. This time Opec will need to make a decision in the backdrop of a radically different world oil market.

Setting the global supply

In 2008, the global demand for oil collapsed as the world slipped into recession. The Opec countries reacted to downward pressures on the oil price in their usual way - by slashing supply. Six years later, the demand for oil remains low, as demand from Europe and Asia is stagnating, and prices up to June were at $115 a barrel. So far, so good.

Suddenly in mid-June the price of Brent starts plunging; it now stands at $80 a barrel - a 30% decline. What would normally follow is Opec would meet, decide on cutting supply, and the oil price would steadily jump back to over $100 a barrel. This is how Opec has historically maintained high oil prices in the face of falling demand.

But this time things are different; Opec has maintained production, in effect permitting oil prices to crash. What has changed? The rapid decline in oil prices is more of a supply story than one of demand.

Oilprices 

The US energy boom

The US recently became the largest producer of petroleum and natural gas in the world. The US energy boom – driven by the production of shale gas– has allowed the country to record its highest level of oil exports in 57 years. US shale has also helped to avert a global energy crisis by compensating for supply disruptions in the Middle East and Ukraine. The implications of the world's traditionally largest importer of oil transitioning to net exporter status are massive.

When Opec meets this week it will have to face this predicament; its ability to dictate world oil prices has somewhat deteriorated. The link between demand and supply that’s been determining world oil prices for decades is at a breaking point. Opec can no longer freely cut supply to increase prices and revenues. If it does, it faces losing significant global market share.

It’s true that US shale entails higher costs of production, even though the price threshold at which US shale becomes uncompetitive is yet to be seen. But within Opec, there is also substantial variation in production costs. This creates divergence between the capacities of Opec countries to cope with lower prices of crude oil. And this increases the probability of conflict within Opec.

USoilproduction 

The Saudi dilemma

Gulf countries have historically preferred a higher oil price but their low production costs mean they can withstand protracted periods of subdued prices. This is especially true for Saudi Arabia, which in addition to low costs, has also cashed in on years of high oil prices to build one of the world’s largest foreign reserves. By contrast, other Opec countries like Venezuela and Iran need high oil prices to balance their budgets and improve their short-term fiscal positions.

A lot is at stake for Thursday’s meeting and the Saudi’s position is likely to dictate the outcome. If they choose to maintain production, the Saudis are well-placed to win a price war against the US but politically this could be a risky move. It seems that the most likely scenario is that Opec will aim to find a compromise between its members and decide on a moderate cut in production to accommodate for an increasingly weak global demand outlook.

 

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