One could only marvel at the impeccable timing of the release of the ongoing study by the Riyadh-based and funded think-tank Kapsarc that is conducting a necessary game theory research in assessing the future of global oil impacts should OPEC dissolve. The overview of Kapsarc’s particulars was reported in the 8 November 2018 Wall Street Journal (WSJ) article entitled Saudi Arabia, OPEC’s Anchor, Ponders a Future Without the Cartel. Although Kapsarc is not independent, their on-going assessments will have a good deal of merit.
The article appeared only days after sanctions were imposed on Iran, about a month before the 6 December 2018 OPEC meeting in Vienna and most recently as Qatar, an OPEC-member since 1961, suddenly announced its departure from OPEC effective 1 January 2019.
Interestingly the markets hardly flinched, neither to Kapsarc’s assessment, a non-independent in-house project by the Kingdom of Saudi Arabia (KSA), nor to Qatar’s announcement to leave OPEC. Nonetheless these announcements and events could presage a change in how OPEC is governed and operates forward.
For decades OPEC, which represents 40% of the world’s oil production through their collective production management and inventory control, has provided acceptable price parameters enabling the oil market to accurately assess a level of risk. Paul Horsnell, Global Head of Commodities Research for Standard Chartered in a 3 December 2018 podcast “OPEC's Crucial Meeting on Oil Prices” at Columbia University Energy Exchange, stated that OPEC is a “stabilizing force” and works to “avoid the (price) extremes.” He also added that based solely on the fundamentals today’s oil prices should be $10/bbl higher.
Throughout OPEC’s history there have been contentious relationships, even war, amongst its members and who remained members. However this is the first time a Gulf country has left the cartel. Notwithstanding Qatar is a special case. Qatar is a minor oil producer of a mere 650,000 bbls/day that represents only 2% of OPEC's production, a literal “drop in the oil barrel”. It’s progressively falling production is due to declining reserves.
On the other hand Venezuela has a present-day production of 1.2 million bbls/day that is twice as much as Qatar’s. The difference is that Qatar’s energy industry is exceptionally well-managed and financially stable and is one of the top three natural gas producers in the world compared to Venezuela, a de facto heavily-indebted failed state will plummeting production due to gross governmental mismanagement and corruption.
For purposes of economic and political opportunities and at times a necessity, OPEC’s alliance with Russia has served both parties rather well with KSA and Russia dictating production levels. However the following developments may change the alliance’s leadership and decision-making dynamics:
- The establishment of the US as a long-term dominant oil producer through the steady shale oil production and surge of production in the Gulf of Mexico making it impossible to offset.
- The oil market’s dynamics are changing and has entered a period of greater volatility and shorter cycles requiring OPEC to be more nimble in their decision-making.
Not long ago when oil prices collapsed resulting a large inventory overhang, OPEC and non-OPEC producers, compliance was exceptionally high. After a brief re-balancing, the inventory overhang has returned as a result of a surge in global production and slowing global demand. For this reason a successful re-balancing will once again require continued high compliance by all OPEC and non-OPEC members. However the condescending attitudes of KSA and Russia towards the smaller producers, many in dire economic straits, by excluding them from unofficial OPEC meetings, has not endeared them to future production compliance.
The nightmare scenario for KSA is not OPEC’s dissolution rather if Russia obtains enough leverage to dictate production terms. Russia is a de facto partner in OPEC enabling them to influence Middle East economically just as they’ve done in Syria militarily for decades. From a political perspective Russia’s regular face-to-face oil meetings with KSA provide an excellent cover to discuss hidden agenda items on non-oil matters in the region.
KSA’s economic situation, at present reasonably stable, is weakening and desperately requires far higher oil prices. According to the IMF KSA requires $73/bbl to balance its budget but has less appetite at today’s lower prices because it foreign reserves have dropped considerably from $750 billion to $500 billion. The challenge to the durability of the KSA-Russia alliance is if it will hold when their respective interests and price targets diverge too far.
In order for OPEC to maintain its influence in a new market environment OPEC must re-invent itself. One possibility is through changes in some of their bylaws requiring unanimous decisions on particular matters which would enable it to become more proactive rather than reactive to avoid lost opportunities. Any dissolution, even an official admission of such a possibility regardless how remote, would result in extreme market volatility which is precisely why Kapsarc serves as the canary in the coal mine.
I project considerably lower compliance among minor OPEC and non-OPEC members that will result in oil prices struggling to gain traction. For this reason re-balancing will take longer than expected. The exception to a slow oil price increase would be any major disruption in volatile areas such as Venezuela, Nigeria and Libya, in addition to any US cancellation of waivers granted to China, India, South Korea and Japan in the purchase of Iranian oil.
Finally, the key to the upcoming OPEC meeting and beyond is the extent of the potential changing dynamic of the KSA-Russia relationship. It’s not so much the production agreement itself, if one is reached, rather how it was reached and whether KSA or Russia had the greater negotiating leverage.
Disclosure: I am/we are long VDE, FSNGX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.