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Dollars Or Barrels: The OPEC+ Challenge

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There is serious concern that the oil price might be getting ahead of the market fundamentals, as I suggested earlier, and this could prove important for OPEC+’s production policy, which now appears to be intended to reduce the global inventory overhang. With oil prices largely recovered to pre-pandemic levels (and pre-Saudi/Russian price spat last year), and the return of backwardation (see figure below), it might seem as if the time has come for additional supply to be released to the market.

Some may wonder at the reported Saudi caution, but this stance actually has a long history. Energy Minister Abdulaziz bin Salman has been studying the market for decades and is no doubt familiar with the experience of 1977, when there was a split within the ranks of OPEC, with most members increasing prices and the Saudis and UAE holding the line. Demand for Saudi oil soared and there was a minor inventory overhang afterwards, which then had to be worked off later, putting pressure on the market in 1977/78.

Then came the Iranian Oil Crisis of 1979. Prices rose from $15/barrel to $40/barrel—nearly two years after the Shah was deposed. The figure below shows the U.S. oil price (see note at bottom) and Iranian production, along with the two most relevant dates: Black Friday, a major demonstration in which security forces killed numerous protesters (September 8, 1978), beginning a round of protests that culminated in the January 16th departure of the Shah. Oil production dropped to near zero in January 1979 (probably all consumed domestically), but recovered to 4 mb/d by April. While that was only 2/3s of the previous level, combined with increases elsewhere, global production had recovered.

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Yet oil prices continued to increase, as the figure showed, peaking in May 1980, over fifteen months after the Shah’s departure and a year after the recovery in production. Indeed, global demand was then-plummeting, falling 2.5 mb/d in 1980 and 2 mb/d in 1981, and inventories were soaring, as the figure below shows. What caused this? Theories differ but generally speaking, hoarding seems to bear the brunt of the blame.

But hoarding is a dependent variable, as the economists would say, while the independent variable, that is, the factor causing the hoarding, was supply uncertainty or more prosaically, fear. Upon ascension to the post of de facto ruler of Iran, the Ayatollah Khomeini called for other countries in the region to adopt the Iranian model of theocracy, which would entail overthrowing their existing governments. This included not only the Gulf monarchies but the secular (albeit brutal) regime of Saddam Hussein in Iraq. Many pundits worried that a wave of violence and supply disruptions might sweep the Gulf, worries that were greatly heighted by the seizure by radicals of the Grand Mosque in Mecca in September 1979. The punditosphere (predecessor to the blogosphere) was filled with warnings of ever-more Islamic revolutions.

The House of Saud withstood that challenge (among many others) despite the predictions of many pundits. But growing tensions along the Iranian-Iraqi border did prove fears of a war between the two to be prophetic. Hussein invaded Iran in September 1980, causing oil prices to soar—by three dollars. At that point, the market was saturated with oil and companies were desperate to get out of purchase contracts that they had only months before been desperate to obtain.

However, based on the advice of nearly every energy economist and pundit, OPEC decided to defend a price close to the disequilibrium level, which was unsustainable. The market weakness (OPEC production dropped by 15 mb/d in 5 years) was exacerbated by the inventory overhand of somewhere near 2 billion barrels. (The above figure shows only inventories in IEA countries.) Arguably the Saudi and OPEC+ goal now is to work off the current inventory overhang as quickly as possible to avoid a prolonged period of pressure from inventory draws.

Unfortunately, traders seem to have decided the market is ‘balanced,’ or at least enough to justify the recent price surge, despite the inventory glut and the massive production shut-in of OPEC+. If OPEC+ members adhere to their quotas relatively closely (no one cares about Congo, sorry), the price will remain relatively close to where it is now. However, that price was sufficient for U.S. shale oil to expand by more than 1 mb/d per year before January 2020, and U.S. producers historically respond to price, not market balances, which implies that drilling in the Permian will soon recover. This will not make the task of OPEC+ any easier over the next few years. Oil traders should invest in seat belts.

Source: Forbes – Business

Dollars Or Barrels: The OPEC+ Challenge

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