OPEC and the Price of Oil

The Organization of Petroleum Exporting Countries (OPEC) recently announced an agreement to reduce oil production by approximately 1.4 million barrels per day (bpd), or about 4%.  Markets responded with a 10% increase in prices.

While OPEC no longer has the almost dominant position it enjoyed during the oil embargo of 1973-74, the group remains in a position to influence prices over the near-term.  Longer term, oil prices are likely to track shifts in supply and demand.  OPEC’s recent move to reduce production is intended to influence the supply side of the equation.

Oil price predictions are very difficult and require a balancing of a number of moving parts.  Consider the following:

OPEC states have a history of cheating on their quotas, and this time is unlikely to be different.

Many major oil producing countries, both in and outside OPEC, are desperately short of cash.  While the best long-term strategy may entail production cuts, politicians tend to focus on the near-term.

OPEC has a major share of the world’s proven reserves and some forecasters believe that the group is well positioned to remain a significant supplier.  However, the issue of proven reserves is complex.  Proven reserves is an industry specific measure of fossil fuel energy sources.  A reserve is considered a proven reserve if it is probable that 90% or more of the resource is recoverable while being economically profitable.  The obvious wild card here is price.  As oil prices go up, so do proven reserves, without any new discoveries.

Production cost has been coming down, making previously uneconomic reserves, profitable.  Despite relatively low oil prices, U.S. shale volumes began to recover in recent months and the trend is continuing.

The demand side of the equation is also complex and can be influenced by such factors as worldwide manufacturing activity, motor vehicle use and efficiency and electric generation, both in terms of demand and fuel source.

Regardless of the above, experts have gone from a generally accepted expectation that the world is in danger of running out of oil, to a new reality that suggests that discoveries are outstripping demand.

All comments and suggestions are welcome.

Walter J. Kirchberger, CFA®