OPEC's Prisoner's Dilemma

In the middle of November, the CEO of Vodafone Vittorio Colao warned of a "prisoner's dilemma" in the efforts to offer bundled television and broadband services.  It makes sense for a company to seek unique content to differentiate it from others.  However, if all the providers try to secure exclusive content, it triggers an arms race of sorts as they all do the same thing or risk losing out.  Colao does not think that securing unique content is necessarily the long-term winning strategy, but if others are starting buying content providers, then it may force him to do the same.

There is another prisoner's dilemma unfolding. The oil producing cartel will be 55 years old next year.    It is not clear, but it may be experiencing an existential crisis.  Its share of the world oil production has fallen with the rise of non-OPEC sources, like Russia, Norway, the UK, Canada, and significantly in recent years, increasingly the US.

In addition to the external threat, OPEC faces internal challenges.  There is a divergence of perceptions of national interest by the political elite.  Indeed, Middle East politics is arguably incomprehensible without appreciating the tension between Saudi Arabia and Iran.

Generally speaking, OPEC countries have tended to fall into one of two groups.  The first has greater oil reserves lower relative to population.  Saudi Arabia and Kuwait are the obvious examples.  The second has relatively less oil and more people.   Iran and Iraq are examples.  This has often created conflicting strategies.  The former wants to protect the value of their reserves by discouraging alternatives, which means relatively low prices.  The latter want to maximize their current value.

OPEC, like all cartels, have governance or enforcement challenges.  It long faced difficulty ensuring that the production agreements and quotas are respected.  By OPEC's own reckoning, there is often production in excess of the prevailing agreement.  Last month, while oil prices were falling, OPEC says that it produced 30.25 mln barrels a day, which is 250k barrels a day over the production agreement. This may under-estimate  OPEC's production.  Iran, for example, appears to be selling greater amounts of (condensate) oil than the sanctions allow.

The prisoner's dilemma is both within OPEC and without.  For the Saudis to continue to act as the swing producer, it would mean the surrender of revenue and market share to its rival Iran.  Iran would very likely use the proceeds for purposes that would frustrate Saudi Arabia's strategic interest.  In a similar vein, a substantial cut in OPEC output, even if it could be agreed up, would benefit non-OPEC producers and only encourage the expansion of US shale development.

Contrary to the some conspiracy theorists who claim Saudi Arabia is doing US bidding by allowing the price of oil to fall to squeeze Russia, it has its own reasons not to want do Russia favors.  Putin's support for Assad in Syria and the Iranian regime puts Russia in opposition to Saudi Arabia.  If the Saudis pick up the mantle again as the swing producer, Russia would a beneficiary.  A recovery in oil prices would allow Putin to replenish his coffers, which would make its foreign assistance program even more challenging.

Moreover, and this is a key point, given OPEC's reduced leverage in the oil market, a large cut in the Middle East production of mostly heavy sour crude might not be sufficient to support prices.  It could lead to a loss of both revenue and market share.    It could also lead to new widening of the spread between Brent, the international benchmark, and WTI, the US benchmark.

The significant drop in oil prices over the last several months has not deterred the expansion of US output.  In the week ending November 7, the US produced nine mln barrels a day, which was the most in more than two decades.  Output slipped in the week through November 14 by less than 60k barrels a day, but we would not read much into that. 

Industry estimates suggest that more than three-quarters of the new light oil production next year is expected to be profitable between $50 and $69 a barrel.  The press reports that rather than be deterred by the decline in prices, some companies, like Encana plan to dramatically increase the number of wells in the US Permian Basin (Texas) next year. 

Reports do suggest that parts of nearly 20 fields are no longer profitable at $75 a barrel.  There has been a very modest reduction of oil rigs.  However, this has been largely offset by the rise in productivity of the existing wells.  For example, in the North Dakota Bakken area, the output per well has risen to a record.  In addition, industry reports suggest that the costs of shale and horizontal drilling is falling.  

Although the price of oil has fallen below budget levels for many oil producing countries, the situation is not particularly urgent.  Seasonally this is a high demand period.  Most countries have ample reserves to cover the shortfall in the coming months.   Around March, the seasonal factors shift and demand typically eases.  That is when some key decisions will have to be made.  It may not sound like a significant tell, but when the next OPEC meeting is scheduled may be indicative of a sense of urgency.  A meeting in the February-March period may indicate higher anxiety than say a meeting in the middle of next year.  

One study by Bloomberg found that only two OPEC quota cuts have been for less than one million barrels.   A Bloomberg's survey found that the  respondents were evenly split between expecting a cut and not, few seem to be actually anticipating a significant cut.  This suggests the scope for disappointment may be limited.     That said, there is gap risk on the US oil futures contract come Friday, when they re-open after Thursday's holiday.  

As a consequence of lower oil prices, some oil producers may have to draw down their financial reserves to close the funding gap.  Some will assume this will translate into liquidation of US Treasuries.   However, it is not as easy as that.  According to US Treasury data, in the first nine months of this year, OPEC increased its holdings of US Treasuries by $41 bln.  In some period last year, it had sold about $17 bln of Treasuries.  Could OPEC countries also be unwinding the diversification of reserves into euros, with yields so low and officials explicitly seeking devaluation (something not seen in the US since Robert Rubin first articulated a "strong dollar" policy almost two decades ago).  

There may be political fallout from a continued decline in oil prices.  An agreement between Baghdad and Kurds may be more difficult.  Pressure in Libya and Nigeria is bound to increase, for example.  

Back in 2009 when some observers began warning that higher food prices were the result of the extremely easy and unorthodox monetary policy.  We argued that the shock was more on the supply side than the demand side and that commercial farmers would respond to the price signal by boosting output.  Oil is similar but opposite.   Oil prices will bottom after producers respond to the price signal by cutting production because they have to, not because they want to.  Fear not greed will be the driver.  It does not look like this can happen until Brent falls below $70 a barrel and WTI is nearer $60-$65.