OPEC and the Elephant in the Room

As oil ministers haggle over the size of an output cut, the threat of recession looms.

Saudi Arabia’s oil minister Khalid Al-Falih has signaled that his country is prepared to cooperate with other OPEC members to cap the organization’s production in order to help boost global oil prices. The conceptual framework for the agreement was established during sideline meetings at an energy conference held in Algeria in late September. It was further fleshed out during a members’ meeting and through comments of oil ministers speaking at the World Energy Conference in Istanbul a few weeks later.

Importantly, the key oil producers have been meeting or communicating extensively in a search for an agreement to limit output. The two-year energy industry nightmare appears to be ending. For industry survivors, the ending can’t come soon enough. For those who have lost their jobs, and there may be more, it comes too late.

A History of Ups and Downs

The history of the oil business is filled with ups and downs, many of them due to the actions of OPEC or its leaders. The Organization of Petroleum Exporting Countries was formed in 1960 in direct response to an existing oil oversupply situation and developing geopolitical pressures – conditions not unusual for the global oil industry. 

In 1959 the industry was struggling with growing output and swelling inventories, partly a hangover from the 1958 recession. A complicating development was the rise of Soviet Union oil output. The Soviets were desperately in need of U.S. dollars and other Western hard currencies to finance their agricultural products and industrial equipment buys. Crude oil was one of the few things the Soviets had to sell.

At one point, Russian oil could be picked up in Black Sea ports for about half the posted price of Middle Eastern oil and with a similar delivery time to market. The price disparity afforded the Soviet Union the opportunity to gain Western European market share at the expense of the major oil companies. Unfortunately, Western Europe was also the primary market for Middle Eastern oil, which those same companies were aggressively lifting. 

After agonizing over how to respond to the soft market and the potential threat from low-cost Russian oil, the international oil companies understood that reducing the posted price for Middle Eastern crude would have a negative impact on the producer countries and create long-term economic and political issues. After extensive discussions and consultations with people knowledgeable about Middle Eastern economic and political conditions, the Board of Directors of Standard Oil of New Jersey (now Exxon Mobil) unilaterally moved to cut the posted price of Middle Eastern oils. It did so on August 9, 1960, by up to 14 cents per barrel, a seven percent cut. The other majors quickly followed. 

Within hours of Standard Oil’s action, activist oil leaders both in the region and outside began mobilizing support for a unified response. Led by the Iraqi government and with the support of two non-Arab countries, Iran and Venezuela, a meeting was organized in Baghdad. On September 8, Royal Dutch Shell, recognizing the whirlwind that had been unleashed, offered an olive branch in the form of posted price increases of two-to-four cents per barrel. The move was too little and too late. By September 10, representatives of major oil exporting countries – Saudi Arabia, Venezuela, Kuwait, Iraq and Iran – had arrived in Baghdad. Four days later OPEC was formed, and the global oil world was forever changed. 

A Delicate Balance

Since that fateful day, OPEC and non-OPEC oil producers have wrestled with appropriate responses to the ebbs and flows of crude oil supply and demand. As is often the case, the margin of error between an oversupplied versus an undersupplied oil market may be merely a few thousand barrels a day. That is where OPEC believes the world oil market is currently heading. Trying to manage that transition is the challenge it faces today. 

The production cap reportedly agreed to by OPEC, with the support of Russia, sets output between 32.5 and 33 million barrels a day. That would put it essentially where OPEC was last January. Importantly, that was the reported cap many OPEC members had agreed to heading into the group’s mid-April meeting in Doha, Qatar, which was sabotaged by Saudi Arabia’s lack of support. 

Times have changed, a fact acknowledged by Al-Falih: “I think market forces have shifted between 2014 and now. I think it’s time to do something different than what we were faced with in 2014.”  He then offered the market some hope for the future when he suggested that it was “not unthinkable” that global oil prices could reach $60 a barrel by the end of the year. He was cautious, however, not to suggest that as a target price. 

Arab Bazaar

As October ended, the OPEC bureaucrats were furiously negotiating the details of the production cap agreement. Like an Arab bazaar, the parties are staking out their negotiating positions as everyone strives to reach an outcome acceptable to all, although someone will always feel they have been taken advantage of. 

With the next official OPEC oil ministers’ meeting not scheduled until November 30, one should expect until then that the media will be full of stories claiming insight into the negotiations. You also can expect to be swamped with words from various government officials, again staking out their positions. Oil traders and speculators will be parsing every spoken and written word, trying to determine what is true and what is for public consumption. Daily oil prices will be buffeted by the differing interpretations of all these words as everyone tries to predict the November 30 outcome. 

Rest assured, there will be an agreement. Will the agreement be substantive, or will it merely be built on a foundation of sand? Like every past OPEC agreement, it is best to watch what the countries do rather than what they say, especially upon emerging from the meeting halls in Vienna. The devil is always in the agreement’s details, and this time those details will matter. With Iran and Iraq, and possibly Libya and Nigeria, being granted exemptions from the production quotas OPEC establishes, the burden of the cutback will fall disproportionally on Saudi Arabia, with potentially non-OPEC supporter Russia bearing some pain as well. 

Recession Ahead?

While many observers will focus on the OPEC agreement as the elephant in the meeting room, it is quite possible that another elephant will be there, but sitting unobserved in a dark corner. That elephant is recession. The current American economic recovery is the fourth longest since the Great Depression. Additionally, there have been a surprising number of recessions early in the term of new American presidents, a transition that will take place in January. Since 1973, every U.S. recession has been accompanied by a decline in American oil consumption. 

Globally, there have been four occasions since 1965 when worldwide oil consumption fell. Two of those declines were associated with geopolitical events during the 1970s – the Arab Oil Embargo in 1973 and the Iranian Revolution in 1979. The most recent decline was in response to the 2008 financial crisis.

Surprisingly, the fourth oil consumption downturn was in 1993, a year after the 1991-1992 U.S. recession ended. The problem was that the recession hadn’t ended in Europe. Between 1992 and 1993, Europe and Eurasia were the only regions of the world where oil use fell. In that case it fell by 1.5 million barrels a day, or 6.9 percent, as Europe and Central Asia’s gross domestic product fell by 8.1 percent. The amazing revelation from studying the consumption data for Europe is that 1992 marked a peak in usage never to be seen again. Oil consumption in Europe and Eurasia in 2015 was 3.8 million barrels a day lower than it was in 1992, a 17 percent drop. 

In the U.S., there have been declines in oil consumption in numerous recession years, but also in other years when the nation’s economy was not officially in a recession. Factors other than recessions were at work during those years. 

The problem today is that virtually no one is considering an oil output scenario that factors in a potential recession in Europe and/or the U.S. Given continued slow global economic growth, primarily in the developed economies of the world that remain major oil consumers, this could present a challenge for OPEC negotiators who, we suspect, are assuming a continuation of the reasonable annual oil consumption growth scenario of 1.2 million barrels a day. If that volume were to drop to zero or turn negative, oil-producing countries will be forced to readjust their output targets, which could undercut the success of any production cap agreement. 

As the world welcomes the end of the two-year oil industry depression that has destroyed hundreds of companies, erased billions of dollars of capital expenditures and eliminated hundreds of thousands of jobs, another jolt to the system when it is least expected would cause further chaos and pain. People should consider a recession scenario as they set their business plans for 2017. – MarEx