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The OPEC Oil Cartel Add in library

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Question:

 

“The OPEC oil cartel no longer exists in any meaningful sense and crude prices will slump to $50 a barrel over coming months as market forces shake out the weakest producers.”

What does this mean for the future of OPEC? Is this a final rear-guard defensive action to preserve their power over oil prices they have enjoyed for 40 years?

 

Answer:

Introduction

Few people would have thought that the oil prices will reach $50 a barrel in the future, but this has happened and things look bleak even now. The shale oil boom followed by the decisions taken by OPEC has completely changed the dynamics of the oil industry. The technology in shale oil extraction has completely changed in the last 5-10 years and the results are now visible. The market has been giving sustainable output for long to price to take nose dive. Coupled with this excess supply there has been slowdown in global growth which is hurting the demand. China being the largest importer of oil has been facing slowdown and now India has surpassed growth rate of China. This is where the demand has considerably reduced and market is well supplied. European region is also facing a slowdown and the same has also hurt the demand prospects. The oil refineries which see good demand during Oct-April, has seen sharp slowdown. The reason for the same is the fact that markets are well supplied. As per a conspiracy theory it has been suggested that ISIS is keeping the black market well supplied. This is also one of the reasons why the problem exists in the market. In the last 40 years OPEC has been controlling the market at large as it is the one which has the largest market share. However in recent times, shale oil supply has tightened the market and good pressure is witnessed in maintaining market share. OPEC countries have been providing its prime client in Asia a good discount. This is where the prices started sliding and the oil prices came from the high of $115 a barrel to $50 a barrel.

In past whenever markets have been well supplied and the prices have come down, that is when OPEC has decided to reduce supply in the market and the prices have rose up. This is where OPEC has been able to control the price in the market for half a century. However in the recent meeting held in November, 2015 the OPEC decided to maintain the output. The main reason has been to maintain the market share in the business. Some of the critical factors that need to be answered is, how long the prices are sustainable? What is the price level which OPEC is still comfortable with? What is the price level when the shale explorer will cut investments and also close shale supply? These are some of the critical factors that need to be answered and the dynamics have completely changed over the last year.

Current Performance

The biggest factor controlling the world production of oil is the world price of oil. A higher price encourages production increases to take advantage of the available profits, while a lower price forces extraction companies to cut back on the production capacity they can no longer afford. Also, when the price of oil is relatively stagnant, as in 2006 and 2007, the Organization of Petroleum Exporting Countries (OPEC) often lowers the production quotas of its member nations to force the price up again. When it does so, as in 2006 and 2007, production from non-OPEC nations increases to compensate. As a result, the world production of oil remained virtually unchanged between 2005 and 2007.

However, the dramatic oil price spike in 2008 caused production to jump for the reasons described above. The global recession followed, and the lowered oil demand it caused the price of oil to fall considerably, which ultimately forced the world’s oil producers to cut their daily production back 0.9% in 2009. As prices recovered rapidly in 2010, so did production, growing by 3.0% to pass the 2008 average. The price of oil resumed growth in 2011, and with it the global supply of oil. In 2013, the price of oil declined, hampering strong growth in the production of oil during the year. Production is anticipated to rebound in 2014, despite a significant decline in the price of oil. In the latter part of the five years to 2015, the world price of oil plummeted due to weak demand and a supply gut. This can largely be attributed to OPEC maintaining production levels, despite falling oil prices. Moreover, the United States is increasingly ramping up domestic production of oil, which is also contributing to the supply glut and weighing on prices. Over the five years to 2015, world production of oil is expected to grow at an annualized rate of 1.2%.

Outlook

The world production of oil will continue growing in the five years to 2020 to match oil’s ever-growing demand. However, the rate of growth is expected to slow as the price of oil reaches a point to significantly slow demand growth. As a result, annual production growth is expected to average just 0.6% over the five years to 2020. However, the timing and nature of OPEC production quota changes are difficult to forecast, and any dramatic changes by the organization would alter world production totals significantly.

The world price of crude oil represents the equally weighted average of oil on three different markets of light crude oil around the world in terms of US dollars per barrel. These markets are for Dated Brent petroleum (38 American Petroleum Institute) in the United Kingdom, Fateh petroleum (32 API) in Dubai and West Texas Intermediate petroleum (40 API) in Midland, TX, United States. Annual figures are presented as the equally weighted average of monthly averages. Historical figures and projections are sourced from the International Monetary Fund (IMF) and the US Energy Information Administration.

Current Performance

Oil prices are highly volatile. A wide range of external factors influence price fluctuations, and these factors include foreign exchange movements, foreign policy decisions, production levels and demand from emerging markets. The most influential development over the past five years has been the increasing emphasis on hydraulic fracturing and horizontal drilling techniques. While upstream oil and gas producers have used these techniques for decades, technological developments have made both hydraulic fracturing and horizontal drilling more efficient and more profitable than ever before. In the United States, the shift towards these techniques has drastically increased production levels, which has in turn pressured domestic prices for both oil and natural gas.

Environmental concerns have increased over the five-year period, and as a result, calls for additional investment in alternative fuel sources have impacted oil and gas producers’ ability to expand operations, especially in offshore arenas. Crude oil prices are largely determined by market conditions, and falling demand can pressure crude oil prices. Though demand for crude oil is projected to remain strong, as it is an input for a wide range of products, high levels of supply, pressure to develop alternative fuel sources and restrictions on crude oil exports in the United States have weighed on crude oil’s price performance over the past five years. For example, as the United States increasingly has supplied itself with petroleum, exporting nations, such as Nigeria and Venezuela, have had to seek other markets for their petroleum output. If the US government continues to reduce export restrictions, US oil will enter global markets, which will further increase supply and pressure prices.

Although overall economic conditions have improved from recessionary lows in 2009, demand from emerging markets, most notably China, has eased in recent quarters. Though rapid industrialization of countries like China and India has boosted demand for petroleum products, high levels of production have pressured prices for crude oil around the globe. In the United States, for example, the inability of producers to export crude oil limits producers’ ability to seek the highest available price for their output. As a result, prices have been falling steadily in the United States since the second half of 2014, as production has continued and surpluses have developed. Moreover, the Organization of Petroleum Exporting Countries (OPEC), in addition to US drilling operators have continued to produce at steady levels despite the recent decline in price. This has exacerbated the build-up in supply and put additional pressure on prices. Consequently, the world price of crude oil is anticipated to fall at an annualized rate of 6.6% to $56.7 per barrel over the five years to 2015.

The world price of oil is expected to trend higher over the next five years; however, it will continue to face downward pressure. US production levels will continue to be strong, and the potential for the US government to reduce export restrictions could further encourage upstream companies to produce at strong levels in the United States. Furthermore, OPEC’s production levels will likely continue at strong levels, further ensuring strong levels of oil supply on global markets. According to the Energy Information Administration’s (EIA) January 2015 Short-Term Energy Outlook, global demand for petroleum and other liquids will average 92.4 million barrels per day (bbl/d) in 2015, and global liquid fuels supply will average 93.0 million bbl/d in 2015. Nevertheless, the world price of crude oil is anticipated to grow at an annualized rate of 5.1% to $72.6 per barrel over the five years to 2020. Although the price is expected to appreciate over the five-year period, this is primarily due to coming off a low base in 2015.

Developments in shale deposits in the United States will continue to encourage growth in production, and the pending approval of the Keystone XL pipeline has the potential to bolster supply levels in the United States. Production in the United States will continue to stress foreign producers of oil and gas, as US appetite for petroleum will be satiated by domestic production, limiting the ability of foreign producers to export to the United States. As emerging markets continue to import petroleum, competition will intensify for exporting nations to supply these growth markets.

 

Volatility

Volatility will be persistent over the next five years, as many exogenous factors can drastically impact overall market conditions. Several oil producing countries face political instability that will continue over the next five years, most notably Iraq and Libya. Additionally, central banks around the world will continue to focus on oil price movements, as low oil prices can benefit a wide range of industries and encourage economic growth. Nonetheless, the potential for sudden price fluctuations will remain constant. Over the next five years, Russian production of petroleum resources will play an important role in European markets for natural gas and crude oil. Countries that are rich in shale resources, such as China and Russia, will challenge the US competitive advantage in hydraulic fracturing and horizontal drilling production over the next five years. However, the US will maintain its advantage in shale resource development due to its developed infrastructure and its access to technology and expertise.

The Global Oil and Gas Exploration and Production industry seeks valuable, natural resources from beneath the earth's surface. Due to the scale of the industry, market concentration is low on a global scale, though regional operators can heavily influence their operational regions. The largest companies are vertically integrated, multinational conglomerates, and when the initial drilling, extraction and transport stages are completed, these companies typically perform refining and manufacturing activities. These activities are excluded from this mature industry.

Movements in oil and natural gas prices relative to production volumes play key roles in determining the industry's performance. Key markets include the developing nations of Brazil, Russia, India and China, also known as the BRIC nations. The emerging industrial capacities of the BRIC nations have driven up the cost for raw energy commodities, as a wide range of manufacturing pursuits require oil and natural gas as key inputs or energy sources for factory equipment.

In the five years to 2015, IBISWorld expects industry revenue to grow strongly at an annualized rate of 5.0% to $4.3 trillion, largely reflecting the recovery from lows experienced during the global recession, when plummeting oil and gas prices brought down industry revenue. In 2015, revenue is expected to fall 8.7%, due to weak crude oil prices.

Volatile prices prevail

Aside from a steep drop during the economic crisis, when global economic activity slowed significantly, oil prices have remained high over the five years to 2015 for several reasons. First, the rapid industrialization of China and India spurred a significant increase in demand as a result of the growing use of automobiles among these countries' sizeable, emerging middle classes. Second, the easiest oil to extract has already been extracted; therefore, every barrel taken from the ground costs more than the one before it. Finally, the rising political instability in many of the leading countries in petroleum production, which are also emerging countries, has caused prices to rise. The Middle East, a main petroleum-producing region, has been in a state of constant tension; consequently, oil prices rose sharply in 2011 as political unrest in Syria, Libya, Tunisia and Egypt threatened to constrain supply.

Meanwhile, continued strong demand for natural gas, especially from Asia, is expected to keep gas prices high, despite skyrocketing production in North America. New pipelines, pipeline extensions and continued growth in demand for liquefied natural gas have underpinned growth in gas output. Gas has also benefited from its status as a relatively clean fuel, particularly when compared with coal. However, the US market has generated a surplus of natural gas that has pressured prices. Nevertheless, the world price of natural gas is anticipated to increase at an average annual rate of 6.9% in the five years to 2015, largely reflecting the recovery from recessionary lows.

Industry profit is expected to grow in line with oil and natural gas prices over the five years to 2015. This climate of rising demand and production has led to increases in industry employment; however, productivity gains have held employment growth down to an average annual rate of 1.2% to 1.3 million employees over the five years to 2015. Meanwhile, enterprise numbers are expected to marginally increase at an average annual rate of 0.7% to 10,011, as existing companies have consolidated to better absorb volatile petroleum price shocks. Indeed, merger and acquisition (M&A) activity was robust in the oil and gas sector in recent years. According to research from Deloitte's transaction advisory business, oil and gas M&A transactions totaled $349.0 billion in 2012 and $205.0 billion in 2013. The majority of new companies are likely focused on developing unconventional resources in the United States, as hydraulic fracturing and directional drilling are currently most prominent in North America.

BRIC demand

While advanced economies, such as the United States, Japan, South Korea, Singapore and those in the European Union, are responsible for much of the total value of the world's GDP, they only contribute small growth to its expansion. Major demand growth worldwide comes from the BRIC nations, all of which are rapidly industrializing countries with massive populations. Other emerging economies have also increasingly ramped up petroleum consumption.

Before the global financial crisis, the BRIC economies experienced strong growth from 2004 to 2007, with the European Union and United States leading demand for their manufactured goods. Therefore, companies in each region have rapidly expanded their infrastructures and services to support the booming trade sectors over the past five years. This rapid development has increased worldwide demand for resources, which has led to soaring commodity prices for oil and natural gas, benefiting exporting countries, especially Russia. In 2015, the BRIC nations' GDP is expected to continue growing, but at a slower pace than in previous years, as international trade slowed down following the global economic downturn. The United States is the largest energy consumer in the world, and increasing US petroleum production lowered the country's demand for imported fuel. Nevertheless, due to the recovery from recessionary lows, international oil and gas trade is anticipated to grow an average of 4.1% per year to $2.1 trillion in the five years to 2015.

Prices recover

The price of oil is forecast to increase over the next five years, largely because oil is continuously becoming more expensive to extract. Areas like the Middle East, which contain major world oil reserves, will continue to remain under constant tension. In addition, increased regulation remains a threat for offshore drilling in the United States following the oil spill in the Gulf of Mexico. IBISWorld forecasts a relatively gradual rise in the price of oil over the next five years as the world economy and, therefore, world demand for oil, recovers from the recession.

However, downward forces on the price of oil will continue. As oil becomes more expensive, the incentive to invest in research for alternatives will also rise. While cars are becoming increasingly fuel efficient, new models are expensive and only widely available in North America and Europe; the global focus on developing fuel-efficient vehicles will likely increase, with countries like China actively seeking to expand their electric vehicle fleet. In addition, substitutes for oil, such as natural gas and biofuels, are increasingly being used as companies try to diversify and decrease their reliance on oil. Lastly, global demand for oil is threatened by a slowdown in emerging economies. In particular, China's GDP growth is anticipated to moderate in the coming years, which can potentially hinder demand for, and the price of, crude oil. Nevertheless, the world price of crude oil is anticipated to grow at an average annual rate of 5.1% in the five years to 2020.

The Global Oil and Gas Exploration and Production industry is subject to a high level of competition. In general, the industry faces competition on two levels: internal and external. Internal competition regards competitive factors common to all or most companies within the industry, while external competition represents threats based in other industries, substitute products or from imports.

Internal competition

Global oil and gas companies compete on the basis of price, although other factors, such as crude oil grades, impurity levels and the costs of extraction also play a role. Competition between oil and gas as fuels is very limited because the two products serve different markets. In the case of oil, the main end-market is that for transport fuels, while for gas, the major markets are electricity generation and gas supply. In addition, a cartel comprising major oil producers known as the Organization of the Petroleum Exporting Countries, or OPEC, aims to have a leveling effect on competition levels.

OPEC's goal is to coordinate and unify petroleum policies among member countries. Prior to the rise of OPEC, large oil companies that possessed the necessary technology and skills for exploration and production dominated the oil sector. At least in part, OPEC was formed to reduce the influence of oil multinationals that had a monopoly on technology. OPEC does not set oil prices, but because the OPEC countries produce about 40.0% of the world's oil supply and their exports account for about 60.0% of the total export in oil, their decisions influence price movements. The purpose of OPEC is to agree on the quantity and price of the oil that member countries export, which lowers competition.

External competition

The industry faces limited but growing competition from other fuels. Oil faces competition from biodiesel (a corn- or soy-based substitute for automotive distillate) and ethanol (typically blended with gasoline, rather than used as a replacement fuel) as the basis for transport fuels. Meanwhile, natural gas faces competition from other fuels, primarily coal, in electricity generation, although it has the advantage of being cleaner burning and producing fewer greenhouse gas emissions. In some applications, notably space heating and cooking, natural gas faces competition from electricity. Renewable and alternative energy sources such as solar and wind power also give natural gas competition as the source of electricity generation.

 

References:

Alkhathlan, K., Gately, D., & Javid, M. (2014). Analysis of Saudi Arabia's behavior within OPEC and the world oil market.Energy Policy,64, 209-225

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‐Rashed, Y., & León, J. (2015). Energy efficiency in OPEC member countries: analysis of historical trends through the energy coefficient approach.OPEC Energy Review, 39(1), 77-102

Barros, C. P., Gil-Alana, L. A., & Payne, J. E. (2011). An analysis of oil production by OPEC countries: Persistence, breaks, and outliers.Energy Policy,39(1), 442-453

Belke, A., & Gros, D. (2014). A simple model of an oil based global savings glut—the “China factor” and the OPEC cartel.International Economics and Economic Policy,11(3), 413-430

Brémond, V., Hache, E., & Mignon, V. (2012). Does OPEC still exist as a cartel? An empirical investigation.Energy Economics,34(1), 125-131

Brunetti, C., Buyuksahin, B., Robe, M. A., & Soneson, K. R. (2013). OPEC'Fair Price'Pronouncements and the Market Price of Crude Oil.Energy Journal,34(4)

Cairns, R. D., & Calfucura, E. (2012). OPEC: Market failure or power failure?.Energy Policy,50, 570-580

Calabrese, J. (2012). have been major changes on the global supply side as well. Oil production in Organisation for Economic Co-operation and Development (OECD) countries is in decline. By 2030, produc-tion in the USA and other industrialized countries is expected to decrease from current pro-duction levels, while OPEC countries are expected to provide most of the increase in world oil output. 8.Handbook of Oil Politics, 401

Colgan, J. D. (2014). The emperor has no clothes: The limits of OPEC in the global oil market.International Organization,68(03), 599-632

Creti, A., Ftiti, Z., & Guesmi, K. (2014). Oil price and financial markets in the main OPEC countries.Energy Studies Review,20(3)

Ftiti, Z., Guesmi, K., & Teulon, F. (2014).Oil shocks and Economic Growth in OPEC countries(No. 2014-064)

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