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Oil & Gas | Commentary

Let It Go

Anger Over Oil Prices Won't Change OPEC's Resolve

By William M. Arnold 

Anger Over Oil Prices Won't Change OPEC's Resolve

This op-ed originally appeared in The Hill

Oil prices are again on the minds of statesmen and executives as world leaders convene at the U.N. General Assembly in New York. Suffice it to say, these are not the 1970s, when oil-shortage angst gripped the United States and Presidents Nixon and Carter urged the nation to make serious sacrifices.

Let’s review what’s going on: Brent oil prices, associated with production in Europe’s North Sea, have exceeded $80 per barrel, the highest since prices collapsed four years ago.

Production constraint by the Organization of Petroleum Exporting Countries (OPEC) and Russia, growing world demand and sanctions on Iranian production have contributed to this surge. This is taking place despite record U.S. production of 11 million barrels a day, which is flooding and disrupting markets.

President Trump has called on OPEC and its allies to increase production to lower gasoline prices, and he has threatened to use the country’s Strategic Petroleum Reserve to unilaterally lower U.S. prices.

But the OPEC/Russia cartel, well aware of how vital oil is to its economies and prestige, has a new vision of its future that they hope will drive prices higher.

Predictions of oil prices are fraught with casualties. Oil prices might again reach $100, but is that next month or five years from now? Pundits brag about the occasional accurate forecast while remaining silent about those that didn’t materialize.

Many factors impact oil prices, ranging from geopolitical risks like Iran, production costs in different countries, shifts in markets (more production in the U.S., more demand in Asia), technical issues like refinery configurations and capacity and logistics. (Brent is already sea-borne while West Texas is landlocked.)

Currently, Brent prices are about $10 per barrel higher than West Texas Intermediate related to U.S. production. Traditionally, there has been only a modest gap between the two, and the balance shifted frequently.

But after the shale boom erupted a decade ago, there was insufficient U.S. pipeline and refining infrastructure near the producing areas. As a result West Texas oil sold at a $23 discount to Brent in 2012.

At the same time, Brent prices were inflated by perceived heightened political risk in the Middle East. That spread dissipated until late last year.

Markets determine prices, and they fundamentally reflect supply and demand, just as we learned in Econ 101. The more interesting question is who and what impacts supply and demand?

The story of the last decade has been the surge in U.S. production and the OPEC/Russia response to it.

The U.S. has become the world’s largest producer of crude oil after eroding in the 1980s and 1990s from a high in the 1970s. Much of this comes from the “shale play,” which combined horizontal drilling with hydraulic fracturing.

Skeptics expected operational costs and infrastructure challenges to cause production to peak and decline. Instead, shale has transformed into a manufacturing process based on constant adaptation of technology and cost reduction.

OPEC, Russia and others were deeply concerned about these new additions to oil markets at a time when global demand was just rebounding from the global financial shock of 2008-2009. OPEC chose to maintain production levels, which combined with the new U.S. production, tanked oil prices from highs near $120 to levels below $30.

Conventional wisdom suggested that shale production costs were around $70, so production was expected to diminish drastically at much lower prices. There was turmoil in the market. Hundreds of corporate bankruptcies took place in the U.S. and more than 200,000 jobs were lost globally.

But the U.S. industry, pressed against a wall, found ways to lower breakeven costs and generate cash flows, often in the $40 price range.

OPEC, Russia and related countries this time responded by agreeing to production cuts that reflected unique characteristic of member nations. The tradeoff was straightforward: Cut production by "X" but world prices rise by "2X" — and the bottom line grows.

To the surprise of market skeptics, the agreements held and were renewed. Now OPEC/Russia see potential for their production to increase as a substitute for reduced Iranian production. But the cartel has not forgotten recent lessons and, under Saudi leadership, is moving judiciously.

As U.S. production reached 11 million barrels per day, infrastructure and operational constraints have been a constant challenge.

There is a huge need for water, for the right kind of sand, for trucks and truck drivers, for rig crews, for pipelines to move oil and the natural gas associated with its production and for export facilities.

This impacts the ability to get it to market and accounts for some of that $10 spread between Brent and West Texas Intermediate prices.

President Trump, not unlike other U.S. presidents at a time of rising gasoline prices, sees a political problem. He proposes using the Strategic Petroleum Reserve to add to production and lower gasoline prices.

The reserve was created, as the name implies, to use in emergencies and not to manage prices. In any case, the reserve is finite and relatively small in terms of U.S. demand. It would be a short-term measure at best.

This week, he has been jawboning OPEC about its production controls. While the markets are free, OPEC is a cartel and, along with Russia, has learned a lot in the past decade about its impact in the face of resurgent U.S. production. It will act in its own perceived interests.

Additionally, the president’s use of tariffs may have unintended consequences. Tariffs on steel impact the capital and operational cost of oilfield production, reducing profit margins and possibly longer-term investment that can restrain U.S. production and raise prices.

Retaliatory tariffs by China on U.S. liquefied natural gas can hurt growing U.S. exports and favor countries as disparate as Qatar and Australia. If a trade war escalates, this could dampen global demand for all products and lower energy prices, but that would be associated with slower global economic growth.

Policymakers — in the U.S. and abroad — need to understand the complexity of this market and the constantly changing dynamics as they consider executive actions, legislation or regulation.

Every action will cause a reaction, but it may not be equally strong. For now, President Trump would be best advised to let the markets play things out. The country is certainly not as handicapped in energy matters as it was in the 1970s.

Bill Arnold was a professor in the practice of energy management at the Jones Graduate School of Business at Rice University.

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