OPEC’s Next Mistake

DANIEL LACALLE: The OPEC meeting has failed, again. The decision to cut production was announced months ago as a great triumph because it included countries outside the organization. And it was a mistake. The result, several months after the largest production cut in history, could not be further from what the organization expected. Oil inventories in the OECD rose to five-year highs, the United States also recorded record levels of crude oil in storage despite a healthy demand, growing by more than a million barrels a day in annualized terms. However, oil prices remained far below those levels desired by OPEC, and especially its more wasteful members, Venezuela in particular.

Why? OPEC has underestimated the reaction of new technologies and independent producers. The cut by OPEC has been the biggest gift to shale in a long time. The US achieved a production growth that has surprised the most optimistic, and the country is closer to energy independence. That the US imports less and stores more, affects oil prices in several ways. On the one hand, US producers have done their homework and increased their efficiency and reduced costs by more than 40%, which has allowed them to be competitive at $45 a barrel. This makes the price of oil lose strength in the face of evidence that the market is better supplied and more diversified than expected.

There is another very important effect. The “oil weapon” mentioned by Chavez years ago has run out of gunpowder. With the drastic reduction of US oil imports, the geopolitical premium historically added to the price of oil due to the US dependence on politically unstable countries, disappears.

Evidence from recent years shows us that the success of the American energy revolution, carried out without any support from the Obama Administration, is twofold. The dream of energy independence of the world’s largest energy consumer is ever closer, and the combination of shale, renewables, coal and natural gas, has been an essential factor in competitiveness, growth, employment and has destroyed the power of OPEC to manipulate the price of oil.

The big mistake

With this meeting, the cartel shows that its control over the price of the barrel in the medium term is non-existent. Worse, if they continue with this policy, the response of alternative technologies will accelerate. The great error of OPEC has been to think that lowering prices would displace alternative technologies and the inexorable advance of efficiency, but the suicidal movement puts at risk OPEC’s role as the most reliable, competitive and flexible supplier. Throwing themselves into unnecessary cuts, they sent a dangerous message to their customers: it was worthwhile to continue to advance with disruptive technologies.

None – I repeat, not one – of the OPEC countries is losing money with the current prices.

None of the OPEC countries is losing money with the current prices. The production and development cost of all members is massively below the current oil price (average total costs $20 a barrel), but member states had become accustomed to financing unproductive subsidies and political spending, to squander their oil revenues. So, despite having costs well below $20 a barrel on average, almost no OPEC country balances its budget at these prices. Between $20 and the $100 some would like to see, there are hundreds of billions of dollars in political spending and subsidies.

I am sorry, because I have had the honor of attending several OPEC meetings and I value the principles that have always informed its policy: to defend an adequate supply and a price that is good for consumers and producers, to be a reliable and safe supplier. We mentioned it in the book The Energy World Is Flat (Wiley), the decision to manipulate the market will only make the market respond more quickly.

Today, OPEC is faced with the devil’s alternative. If it continues to limit production, the response of efficient operators in different technologies will accelerate, and if it recovers production levels prior to the cuts, it will not be able to finance the excessive expenditure to which the member countries have become accustomed.

OPEC’s response should only be one. Demonstrate that they are the most efficient and reliable operators and that their governments can stop irresponsible spending. Only in this way will these countries, full of wonderful opportunities, remain relevant and prosperous.

“Low” oil prices are a blessing in disguise to producers, even if they do not believe it. It is the shock they need to wake up from the nightmare of the petrostate, that wastes billions of oil revenues and thinks it will go on eternally. Disruptive technologies are here to stay and have only one future: brilliant. | Daniel Lacalle | Friday, May 26, 2017

© Daniel Lacalle

All Rights Reserved

Daniel Lacalle has a PhD in Economics and is author of “Escape from the Central Bank Trap”, “Life In The Financial Markets” and “The Energy World Is Flat” (Wiley)

You can comment on this article at Dr Daniel Lacalle’s website here

OPEC Strategy Has Backfired. And It Could Get Worse

DANIEL LACALLE: Nervousness is palpable ahead of the next OPEC meeting in Vienna. The cut in production agreed with some countries such as Russia has been an absolute failure. Not only OPEC has failed to raise the price of oil, but the market share of their main producing countries has been reduced.

If anyone would have told Saudi Arabia that the deal would push the price of oil to its lowest level in six months, increase its main rival’s market share, and strengthen the fracking industry in the US, they would not have believed it. And that is exactly what has happened. No one can say I did not warn them.

Iran expects to increase production capacity by 3 million barrels a day according to the Shana news agency and official sources. Iraq remains at record levels, exporting 3.2 million barrels per day.

In the United States, shale alone has boosted production to 5.2 million barrels a day in May, 700,000 more than at the end of 2016. Between the increase in output of Iran, Iraq and the United States, they cover almost all of the cut agreed.

Iranian and Iraqi barrels are of the highest quality and very low cost, while US production costs have been brutally reduced. BP, in its earnings presentation, commented that its production in deep waters in the Gulf of Mexico can compete without problems with a shale production that already has a break-even price of c$45 a barrel. Thanks to efficiency and cost reduction, production in the Gulf of Mexico has also skyrocketed, bringing total US production to 9.3 million barrels per day, the highest level since 2015.

The OPEC cut has been the biggest gift to independent producers who have improved efficiency. It has allowed them to generate better returns at low prices, and increase market share.

Meanwhile, Saudi Arabia is the only country that has exceeded its commitment – as always – and delivers the biggest cut of all.

The price of oil is suffering because production is increasingly diversified and, as such, the geopolitical premium we attach to crude prices disappears and the ability to control prices of OPEC diminishes. Not only that, but inventories are at a five-year high, and have increased in the US by 10% since the OPEC cut, 30% above the average of the last five years.

The mistake of inflationists with the price of oil is threefold:

• To think that the reduction of investments will generate a boom in prices in the medium term. Not only is capex growing at an annualized 8%, but they forget that the “reduction” came after a spending bubble in the easy money decade that led to a huge productive overcapacity of close to 30%. Investments in exploration and production multiplied in ten years to more than $1.2 trillion per annum, fueled by inflated commodity prices – in dollars – due to monetary policy and estimates of science fiction-style Chinese growth, with no fundamental justification and based on bubble expectations. Today, those massive investments have become sunk costs and work just to generate cash. What we call “energy broadband” in The Energy World Is Flat (Wiley).

• Ignoring efficiency and technological substitution, which are unstoppable and withdraw each year, according to the IEA, up to 2 million barrels a day of potential demand. Many think that OPEC cuts will work as demand grows. Let us not forget that, as soon as the demand begins to work better -and it is not bad- OPEC will start to “cheat” on those cuts, as it has always done, since there are no individual quotas and, when there are, many ignore them . To give you an idea, the average “cheat” in OPEC cuts since 1980 is between 450 and 800,000 barrels a day.

• The lower the price, the more efficient the system. Global service companies have shown in their results this quarter that they can lower prices by 40-45% and still make money and grow.

OPEC strategy has backfired. But it can get worse. If consumer nations continue to perceive that the cartel is not a reliable, flexible and efficient supplier, and that its aim is to raise prices at any cost, the policies to reduce energy dependence will accelerate, just as solar and wind are becoming more competitive and electric vehicles are a reality. OPEC does not have a cost or profitability problem. All countries are making very positive returns at $45-50 a barrel. Those that are not making money is because they have massive cross-subsidies and political spending, not high production and development costs.

Many will tell you that “in the medium term” the market will balance … And they said the same thing two years ago, a year ago, six months ago… But they ignore that balancing does not necessarily mean price inflation. Because the technology, substitution and diversification revolution is much faster than the interventionist decisions of central planners. | Daniel Lacalle | Tuesday, May 10, 2017

© Daniel Lacalle

All Rights Reserved

Daniel Lacalle has a PhD in Economics and is author of “Escape from the Central Bank Trap”, “Life In The Financial Markets” and “The Energy World Is Flat” (Wiley)

You can comment on this article at Dr Daniel Lacalle’s website here

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