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“OPEC – What is happening to oil prices?”

 

Organization of the Petroleum Exporting Countries, first launched in 1960 is the group of 14 countries centred around the Middle East which represent around 45% of current world oil production, and almost 75% of current known oil reserves.

In the 1970’s and early 80’s OPEC managed to limit the levels of oil in the global market place which saw high price rises of more than 400%, which in turn forced many large oil using countries to look at alternative sources for oil such as The North Sea for the UK. The net effect of this was to see the oil price crash in the mid 1980’s, falling by more than 50% in 1986 alone.

OPEC has not been anything like as high profile in the main stream media since that time, partly due to the fact that they have struggled in recent years to control the price of oil in the same way as they did 30 years ago.

The main factor that has thrown the market in the past 5-10 years has been the incredible growth of Shale Gas extraction in the US. This shift has allowed the US to become a net exporter of oil and gas, and even led to President Obama lifting the long term ban on export of crude oil from the US. In simple terms, Shale Gas is a game changer.

In response to this threat, Saudi Arabia the largest producer of oil, and the defacto leader of OPEC took the unilateral decision to keep producing at full capacity, even as the shale gas impact drove the oil prices down. Traditionally, OPEC would have cut production to hold prices higher, but Saudi Arabia seems to have made the judgment that the only way to stamp out the threat from these new forms of oil and gas was to allow prices to fall to make them no longer viable.

This has caused huge issues for the other OPEC members, who need high prices to keep their national economies in surplus, but Saudi Arabia has ignored calls to slow production and has absorbed huge losses from its own financial reserves in an attempt to drive out competition. This has indeed caused huge problems for all the other oil producers.

In the North Sea in 2010, the UK Exchequer raised 50 billion in direct tax revenue from the oil companies in the North Sea, by 2016, this tax take was a mere 50 million. In response, from 2014-2016, the North Sea operators lowered their costs of production by around 10%, but it still stands well above the current global price of oil.

In the US, the Shale Gas businesses have come under the same pressures, but since 2014, they have managed an incredible 65% reduction in extraction costs, which means they can still make money at the current oil prices.

This week in Vienna, OPEC have finally agreed a cut in production of around 4% to come into effect by January. This was a surprise for the markets, as this is the first deal for 8 years within OPEC and saw a rise of between 6% and 10% in trading after the announcement.

 

The big question for customers of oil products, and those that supply it, is what does this mean for oil prices in the future?

 

Of course, no one actually knows, but it seems to me that much depends on how well the OPEC countries actually deliver on their promise to cut production. The organisation is an unstable mix of countries with many complex relationships that go well beyond economics. Since the 1970’s OPEC has struggled to keep all these members in line, and often deals have been done, only to be broken soon afterwards.

If this deal sticks, if indeed all 14 members reduce production as per the agreement, I think it is highly likely this will be a sign that OPEC has regained control over the global price of oil, and I would expect that they will look to repeat this production cut over the next few years and push up oil prices accordingly.

However, there are a number of other forces driving prices down. As prices rise, more and more US Shale Gas will come on stream, China’s demand is slowing and the Western Economies are showing limited growth and a much higher use of oil alternatives – all which keeps the prices lower.

The other major factor for us in the UK is the Sterling:Dollar exchange rate. With Brexit and Trump in the mix, it would be a brave call to what will be the longer term trend for exchange rates. The stronger the pound, the lower the price of fuel in the UK. Post Brexit, the pound fell around 20%, and fuel prices rose exactly the same amount.

 

So what does that mean for oil prices for our customers?

 

I sat in  an industry briefing from a very smart Oil Industry Economist who pointed out that all the models for pricing he had been taught whilst working within the major oil companies had been torn apart by what has happened over the past few years – we are in unchartered territory, there is no one who can give a confident prediction of where pricing will go, but if the past couple of years are anything to go by, it is fair to say that prices will remain volatile until such a time as the markets find their level.

The good news is that against traditional benchmarks, oil in the UK is still relatively low, how this will change in the coming months is unknown, but it would take a dramatic rise to return to the levels of 2010 in the short term. There are always options to fix prices for 12 months, which are more expensive than paying the price on the day, but at least it takes the worry of what OPEC, Brexit, Trump and the rest of the unknowns are up to.

Chris Bingham

 

Update: 06/12/16

 

In way of a short update since this post was originally written. The OPEC block seems to be continuing to keep the price high. However, (for a range of reasons) the pound has continued to strengthen against the dollar which for most of us is taking the sting out of the higher oil price.

 

More updates as things develop further.

 

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