OPEC Strategic Blunder – Oil Industry is on Ventilators!

By Dr. Salman Ghouri 

OPEC’s strategy in the past has been to maneuver its oil production to bring about market stability. However, the penetration of U.S. shale oil forced them to alter their strategy in favor of market share even at the cost of lower oil prices. Recently, Russia decided not to collaborate with OPEC in cutting oil production. OPEC’s traditional strategy is cutting oil production, but the Saudis decided to utilize their excess capacity to enhance oil production. In this way, Saudis wanted to destabilize the oil market targeting the booming US shale oil industry. The sensitive market reacted immediately resulting in the collapse of WTI to around $31.13/bbl on March 9 from a high of $47.18/bbl on March 3, though prices further dipped to 22.84/bbl by March 18, 2020. The oil prices have fallen further due to COVID-19 which is currently gripping the whole world - weakening global oil demand – causing excessive surplus. One should not forget that a similar strategy was adopted by OPEC in 2014/16, but it was unsuccessful.  At the end of Dec 2019, US shale oil production reached 9.12 mmbd even though the average WTI was hovering in the fifties as compared to 5.11 mmbd in Sept 2016.

Methodology and data

Since the objective of OPEC seems to destabilize the US shale oil industry by means of weaker oil price strategy, we decided to check the sensitivities of US regional shale oil producers. In an effort to explore the possible implications on US shale oil we have used the econometric model and used different possible oil price paths. Three scenarios are used. Firstly, what if oil prices are allowed to gradually increase to Dec 2022 reaching $56/bbl? (Reference case) Second, what if oil prices remain weak over the forecast period below $39/bbl? (Low case) Finally, what if oil prices are allowed to increase reaching $74/bbl by Dec 2022 (High Case)? The objective is to check the possible threshold at which US shale oil production survives/perishes.

We have used monthly data for U.S.’s seven shale regions (Anadarko, Appalachia, Bakken, Eagle Ford, Haynesville, Permian, and Niobrara) from January 2007 to Dec 2019. Figure-1 illustrates the oil price actual average monthly West Texas Intermediary (WTI) data (January 2007 to Feb 2020). Figure-2 depicts WTI forecast prices until December 2022 under alternative scenarios. The oil production for each regain is run against monthly average WTI prices from January 2007 to January 2020.

The historical data reveals that there is lag structure involved with changes in oil prices. When oil prices decreased/increased, the production did not decrease/increase instantly—rather it took a number of months. The timings of response varied from region to regions but generally six to eight months before the full impact is realized. We have run several polynomial distribution lag models (Almon) with various lag structures and (Koyack) model. Each regression is run with and without constants and also used an autoregressive/moving average scheme to correct autocorrelation problems if required. The best estimated model for each region was selected and then re-run to forecast respective regions’ shale oil production under alternative price scenarios.

Shale oil production forecast alternative price scenarios

Figures-2 to 9 depict US regions shale oil production forecast under alternative oil price scenarios. Based on our best estimated models U.S. shale oil production is expected to decline in all the regions in response to plunging oil prices. Generally, US shale oil production revives in almost all the regions once oil price reaches $49-50/bbl range, although Appalachia production only revives when oil prices hit $59/bbl.

When oil prices are allowed to increase, US shale oil production under the reference case is expected to increase after a lag of eight to ten months.  However, response varied from regions to regions. For example, Anadarko, Bakken, Eagle Ford bottomed in November 2020. Permian bottomed in October 2020 while Niobrora bottomed in May 2021. All the regions failed to recover their respective Dec 2019 production levels.  

Summary of Forecast

Table-1 illustrates the summary of US shale oil production forecasts under alternative oil price scenarios. Under the low oil price scenario production declined in all the regions and revived with the gradual increase in oil prices, yet failed to regain their respective Dec 2019 production level. In this scenario oil prices are assumed to remain between $20 and $39/bbl. This strategy could hurt US shale oil production as by Dec 2022 shale production decreased by 1.72 mmbd compared to Dec 2019. Higher oil prices assumed a price range of $20 to maximum of $74/bbl and continues moving upward. Generally, all the regions under high oil price scenario surpass their Dec 2019 production level. Anadarko, and surprisingly the US’s most prolific Permian region, failed to regain Dec 2019 level of production. US total shale oil production increase to 9.56 mmbd in Dec 2022 under high oil price regime compared to 9.12 mmbd in Dec 2019.  

Table-1: Summary of US Regions Shale Oil Production Forecast – alternative oil prices scenarios

Note: the numbers may not round.

Implications on oil industry

No doubt, this strategy will affect US shale oil producers provided OPEC is prepared to maintain lower oil prices within $20 - $39/bb or even in the range of $20 - $54/bbl (Reference) till Dec 2022. If oil prices were allowed to surpass fifty dollars, US shale industry generally would revive successfully. Unlike in the past, this time the US government prepared to shoulder the shale oil industry. In fact, the US government already decided to buy 77 million barrels for strategic petroleum reserves (SPR), a move to insulate US shale oil producers from possible bankruptcies. Therefore, the fallout of continuing to pursue this strategy will be more harmful to OPEC and other oil exporting countries than US shale industry.

Why this Strategy Short Lived?

Saudis are not only losing oil revenues due to lower oil prices but also due to lavish discounts to capture market share.  In addition, to avoid the wide spread of COVID-19 the government has put a ban on Umrah (pilgrimage). It is adversely affecting the hotel/tourism industry. The fallout is quite substantial as economic activities have stagnated. Millions of pilgrims who used to spend millions of dollars every day on goods and services during their stay is lost. Additionally, Saudi government requires a price tag of over $80/bbl to balance its budget has no option but to withdraw huge resources from sovereign funds to keep their economy afloat. The question is how long? Saudis have this liberty but it will have devastating impact on other fellow OPEC members and non-OPEC oil exporters. Most do not have enough resources in sovereign funds and with lower oil prices will have difficulty meeting budgetary requirements. To deal with the COVID-19 pandemic requires enormous resources. How they will survive?  

The analysis concluded that U.S. shale oil industry is insensitive to changes in oil prices in the short-term, but strengthen/weaken in the longer term with the increase/decrease in oil prices. When oil prices increase, shale oil production increases but when it declines it takes number of lags before its impact is fully realized. Under the high case scenario all the regions except Anadarko and Permian generally recover the lost share in production and also surpasses their respective production level of Dec 2019. However, under a persistent lower oil price regime the U.S. shale oil industry loses 23.4% percent of their production as compared to Dec 2019. The question remains whether OPEC will pursue this strategy over a longer term? I doubt that Saudis and OPEC can pursue such a strategy any longer because the oil industry needs trillions of dollars of investment in sustaining and enhancing future oil production. If such strategy continues, it means choking out the much-needed oil industry ventilation and may permanently damage the oil industry. I strongly believe very soon that this strategy will be reversed and market will find its natural way based on demand/supply fundamentals, allowing the oil industry much needed oxygen. Yet this strategy is beneficial for the oil importing countries to deal with COVID-19 and overcome its aftershocks.  

One thing is for sure that current oil price regime provided an opportunity to oil industry (particularly OPEC members) to prepared themselves to live in an environment of oil price between $30-$50/bbl or maybe less! One should not ignore the speedy penetration of electric vehicles (EVs) and its possible fallout on global oil demand that could possibly displaced 38 mmbd by 2040. It is good time to develop strategies to diversify their oil-based economies rather than spending time in market interventions.