Has OPEC learned from past mistakes?

The recent partially post covid-19 global recovery witnessed sudden spike in oil demand. The lack of past investments in oil and gas industry and supply chain constraints led to surge in oil prices. This was expected to happen. The sudden oil demand exceeded supply, leading to higher oil prices. Consequently, this led to debate and seasonal analysts, particularly investment bankers and other consultants, who are forecasting oil prices may reach $100/bbl. The recent tussle between United Arab Emirates (UAE) and Saudi Arabia on production quota no doubt further strengthens their arguments.

This is quite possible, as oil revenues is the major contributor in economic development of most oil producing countries, particularly OPEC members. To balance their budgetary requirements, some countries look $100/bbl oil or even more. The higher oil prices surely facilitate in achieving this goal. However, the global economy is still vulnerable and not fully recovered from Covid-19 and following different variants. The question one needs to ask is whether OPEC will repeat their past mistakes to achieve such level of oil prices by manipulating oil production?  If yes, then do we expect revival of US shale oil industry and subsequently collapsing of oil prices? Or OPEC might have lessons learned and may not allow oil prices to surpass over $70/bbl for considerable months.

Both the scenarios are possible, it requires a number of months for US shale oil industry revival and number of years for new oil discoveries and development and production.

Possible Rebound of US Shale Oil Industry

Persistently lower oil prices from 2014 to 2016 and eta of covid-19 led to underinvestment in upstream and fewer Final Investment Decisions for oil projects. Investments in upstream, for example, plunged from $1079 billion in 2014 to $900 billion in 2015 and then further down to $583 billion in 2016. This is because lower oil prices severely affect the revenues, cashflows, and profitability of oil and gas companies. That leads to fewer resources being available for future investment in exploration and production activities. The question now, is what will happen to the oil and gas industry post-COVID-19? Should we expect the regime of higher oil prices to linger or will oil prices slump back into $60/bbl or below? 

Figure-1 & 2 clearly demonstrates that US shale oil production in the past has increased/decreased with number of months lags in response to increase/decrease in oil prices. My assessment is that OPEC members have already learned from their past mistakes and surely will not allow oil prices to surge beyond $70/bbl for considerable months. The reason is that they know global economies are still vulnerable and weak. The combined impact of higher oil prices and covid-19 may adversely impact the revival of global economies. They are quite aware of the fact that sustained higher oil prices will allow US shale oil industry to rekindle its lost glory.  In addition, speedy penetration of electric vehicles (EVs) and significant increase in the role of renewables could eventually impact the global oil demand. 

Figure-1: Us Shale oil production trends by basins

Figure-2: Historical relationship between WTI and US shale oil production

In the past, the US shale oil industry response to higher oil prices as illustrated in Figure-1. Figure-2 depicts US Shale oil production did increase with 6-8 month lags (though lags vary from basins to basins) in response to higher oil prices. The question is can we expect US shale oil industry enhance their investments in response to higher oil prices? Well, it depends on companies’ financial health (for more details). Generally, most suffered heavy losses and in the process of consolidating their cash flows and clearing off their debts. They might be cautious in sudden increasing their investments in drilling of new wells. Nevertheless, their first priority would be to target drilled and uncompleted wells (DUCs). If the expectations are that oil prices to remain over $65/bbl for considerable period, one could expect increase in drilling activities and higher U.S. oil production. In fact, in response to recently higher oil prices Permian basins production is already showing signs of recovery.  In addition, the number of oil and gas rigs in the United States is up to 5 this week, according to Baker Hughes. This is just a meager increase, but total rig counts up to 484, as compared to 231same time last year (Figure-3).

 

The U.S shale oil production peaked in January 2020 to 9.15 mmbd and then declined to 6.55 mmbd in February 2021 in response to plunging oil prices. However, since than shale is on the upsurge. By June 2021, it already hit 7.77 mmbd. The EIA’s estimate U.S. total oil production for the week ending July 7 was 100,000 bpd higher than the previous week at 11.4 mmbd. A sign of recovery as oil production by the end of May 2021 was dropped to 10.8 mmbd. Since then, it is on the rise.    

  

Figure-3: Historical relationship between WTI and total rig counts

If OPEC hasn’t learned from their past mistakes and failed to resolve dispute on quota amicably, they are adding uncertainty to oil market. The element of uncertainty at this juncture when global economies are in the process of reviving may hinder this recovery process. The covid delta variant is already a sign of hazard.  They may gain out of this strategy short-term., eventually they may have set themselves up for failure. Not only from expected increase in US oil production but this time damage could be deep due to other factors. The world is already witnessing higher inflation. Even developed countries like USA is not spared. For example, the annual inflation rate for the United States is 5.4% for the 12 months ended June 2021 after rising 5.0% previously, according to U.S. Labor Department data published July 13 2021.  The higher oil prices, delta variant and constraints on supply chain will further push the inflation. This will eventually create weak global oil demand and in turn subject to downward pressure on oil prices.

Now its up to OPEC members to look for short term gains or long-term losses!