OPEC Losing Its Grip? No, The Saudis Are Partying Like It's 1981

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Falling oil prices have provided the equivalent of a $1 billion-a-day tax cut to U.S. consumers. That’s the good news. The bad news is despite all the crowing about OPEC losing its ability to control oil prices, quite the opposite might be happening. The Organization of the Petroleum Exporting Counties, and particularly Saudi Arabia, are partying like it’s 1981, with Republicans in control of Congress and alternatives to oil in retreat. That means lower oil prices, possibly for years, but also lower non-OPEC energy production and eventually another recession-inducing price spike like the one that helped take down the global economy in 2008.

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I get large parts of this contrarian scenario from Martin E. Cobern, a longtime oil-industry executive who has a Ph.D in physics from Yale and helped develop some of the key technology behind horizontal drilling as head of research at Teleco Oilfield Services and later APS Technology.

Just as I remember well being in Houston when oil prices fell below $10 a barrel in 1997, Cobern remembers the recessionary 1970s, when oil prices were driven up by two mostly political crises; and the early 1980s, when OPEC opened the spigots and drove the price of oil from an inflation-adjusted $112 a barrel to below $30.

Then, too, people celebrated the defeat of OPEC. President Ronald Reagan famously ripped Jimmy Carter’s solar panels from the White House roof, saying the free market could solve America’s energy needs. But amid all the celebrating, many forgot the primary purpose of a cartel: Not to drive up prices, necessarily, but to drive competitors out of the market.

“Since their beginnings over 150 years ago, oil cartels from Standard Oil, to the Texas Railroad Commission to its clone OPEC have been successful in controlling the market,” Cobern wrote in a recent article he shared with me. “The primary approach was to make competition economically impossible.”

(A historical digression here: The Texas Railroad Commission seized control of the state’s oilfields in 1932 to stop a freefall in prices from $1.10 a barrel to 10 cents as huge oilfields in East Texas came on line at the same time as the economy slipped into depression. A Venezuelan lawyer, Juan Pablo Perez Alfonso, studied the actions of the Texas Railroad Commission and proposed a similar organization to cartelize the world’s oil exporting nations, which became OPEC.)

What goes down, however, must eventually go up. Oil is a finite resource, even if new technologies sometimes make it seem infinite. The mid-1980s price collapse was great for U.S. consumers, just as Americans today are enjoying the equivalent of a $1 billion-a-day tax cut thanks to the $50 per barrel plunge in crude prices.eia oil price
Lower oil prices and the Republican ascendancy also strangled the infant renewable energy industry, however, and combined with the Three Mile Island disaster in 1979 helped kill nuclear power expansion for 30 years.

Oil prices cycled between an inflation-adjusted $25 and $40 per barrel for the next 15 years, except for a spike past $60 in 1990 triggered by Iraqi dictator Saddam Hussein’s invasion of Kuwait, which helped trigger the 1990-91 recession. Then in 1997, prices began to slide in what turned out to be a symptom of the Asian financial crisis that emerged full-blown the following year.

Then, as now, a major financial downturn combined with growing North American oil supplies from the deepwater Gulf of Mexico and disarray within OPEC itself to drive prices below $10. Faced with a seemingly uncontrolled freefall in oil prices, Saudi Arabia returned to the one power it still held: To drive higher-cost producers out of the market. Saudi Oil Minister Ali Naimi, in a revealing December interview, describes how he bluntly threatened the Venezuelans with punishment if they continued to exceed their production quotas. When they refused, the Saudis carried through by continuing to pump as prices fell.

This cycle of control and disarray repeated itself in 2008, Cobern says, when rising global demand hit the limits of peak oil. Not peak oil in the sense of a permanent decline in production, but in the sense of no additional barrels immediately available to supply demand. Speculators sensed OPEC couldn’t pump enough oil to stem the rise in prices, Cobern says, exacerbating the increase and helping to trigger the next recession. (An overinflated U.S. mortgage market supplied the other key component to the crisis.)

Once again higher prices stimulated technological development in the oilpatch. Drillers combined horizontal drilling with the decades-old technology of fracking to unlock huge reserves of oil and natural gas in North America. But the Saudis are patient. They know how the cycle of development, capital formation and exploitation work. As supplies grew and oil-industry executives and politicians crowed about a coming era of U.S. energy independence, prices began to weaken. Then in July they entered freefall, plunging from almost $100 a barrel to below $50.

It will take time for all those new supplies to come out of the ground, but already U.S. producers are starting to cut back on capex and lay off workers. Steep decline curves and a dearth of new investment will take care of the rest. A rule of thumb, Cobern says, is for every ten unconventional wells drilled this year, North American oil companies must drive seven or eight next year to maintain the same level of production. The chart below from the Energy Information Administration’s May, 2014 annual overview shows the general trend, which no doubt will accelerate given low prices.

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Once OPEC and the Saudis have flushed all the high-cost production out of the market – Naimi’s stated goal, according to the December interview – it’s just a waiting game until demand catches up with supply and prices begin to rise. Eventually, perhaps before 2020, there could be another price spike, triggering another recession, and the oil exporters will have once again demonstrated their control over the economies of consuming nations.

As a pair of IMF economists explain in this recent article, the futures markets already forecast a recovery to $73 a barrel by 2019. Rystad Energy in Oslo has done detailed analysis of North American production and estimates the break-even prices of the main U.S.shale fields in the Bakken, Eagle Ford and Permian are still below $60 per barrel, so drillers can keep pumping for a while. But the returns on capital will be too low to keep drilling at those prices. Big companies like Halliburton, Schlumberger ConocoPhillips and Royal Dutch Shell are cutting jobs and eliminating marginal projects, including Shell’s $6.5 billion gas-to-liquids project in Qatar.

For Cobern, the plunge in oil price is a call for increased investment in conservation programs, renewable energy and nukes, to avoid the cycle repeating itself. To which I say, good luck with that. Not only has there been a bad track record for jump-starting alternative energy before consumers want to buy it, but the wrong party is in control of Congress. We’re partying like it’s 1981, and that’s likely to continue for a while.

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