Some of the world’s largest oil producers are trying to see if they can lift up crude prices around the world by artificially throttling production. So far, they’ve been pretty successful, at least on paper.
On Monday, global oil prices rose to $55 per barrel, the highest level since mid-2015. The impetus? Russia and other countries just agreed to voluntarily cut their oil output, following a huge deal in November by the Organization of Petroleum Exporting Countries (OPEC) — which includes Saudi Arabia, Iraq, and Iran — to limit production:
These countries are hoping that they’ll benefit from a coordinated production cut — that they’ll gain more revenue from higher prices than they lose in lost output. One big question, though, is whether they can actually enforce this tricky agreement. And it’s also unclear how US fracking companies will respond to this move — they could end up ramping up production and causing this whole deal to collapse.
Why OPEC and non-OPEC countries are suddenly cutting production
Quick recap on how we got here: Ever since mid-2014, the world has been pumping out far more oil than anyone needs, due in part to the fracking boom in the United States and to slower-than-expected demand in places like China.
And for much of that time, OPEC just sat by and did nothing as prices fell. The cartel’s most important member, Saudi Arabia, actually thought it would be better to flood the global market with crude in order to drive prices down and put all those high-cost US shale companies out of business. As a result, oil prices absolutely plummeted, at one point falling below $40 per barrel.
Two years later, however, things look different. US production has now fallen from 9.6 million barrels per day down to 8.6 million barrels per day amid the price crash. Nearly $1 trillion in oil investment worldwide has dried up. Meanwhile, Saudi Arabia has been hurt badly by the price crash. The country has already burned through more than $100 billion worth of foreign exchange reserves and has been forced to cut social services and government salaries to compensate for lower oil revenues, threatening stability in the kingdom.
So, this year, Saudi Arabia and other OPEC countries finally decided that enough was enough. In late November, the cartel agreed to a major deal to limit oil production to to 32.5 million barrels per day — down from their current levels of 33.7 million barrels of oil per day. (OPEC represents about one-third of the global market.) Saudi Arabia, Iraq, UAE, and Kuwait agreed to make the biggest cuts, which totaled 1.2 million barrels per day in all. Oil prices surged worldwide after the agreement.
But there was a catch: OPEC’s members said that as part of the deal, they wanted other non-OPEC oil producers, especially Russia, to make their own cuts worth 600,000 barrels per day. Over the weekend, the non-OPEC countries agreed to (mostly) do just that, signing onto cuts worth 558,000 barrels per day. [] In response, Saudi Arabia suggested that they might cut even further.
So that’s what’s responsible for the current oil rally. It will mean more revenue for countries that export oil and shore up their budgets — but it will also mean higher prices for drivers in the United States and elsewhere.
It’s still unclear if the OPEC deal will hold — and the United States is a wild card
Now, it’s unclear if Saudi Arabia, Russia, and the rest of these countries can actually hold the line and successfully limit global production. In the past, both OPEC and non-OPEC countries have been known to cheat on agreements to limit production. “That’s something we’ve absolutely seen in the past,” says Bordoff.
OPEC’s members (and non-OPEC countries like Russia) face a big coordination problem. Each of these oil producers would benefit from higher global prices, but every individual country would rather that someone else make the actual cuts. Without any real enforcement mechanism, the incentives to cheat are high.
Even if this deal is successful, however, these oil exporters faces another, more serious quandary. Over the past two years, the fall in oil prices has put a damper on project investment in places like the United States and Canada and Brazil, because fracking and oil sands and deepwater projects need relatively high prices to make investing worthwhile. That crimp in investment has helped stabilize prices around their current level.
But if OPEC successfully throttles back on production and hikes prices, that could induce some fracking companies in Texas or North Dakota to attract enough investment to start drilling again. At that point, supply would rise and prices would fall. OPEC would be right back where it started — except it would have lost market share.
The tricky part is that no one knows exactly how this dynamic would play out. Bordoff notes that forecasts vary wildly on how much US oil production could grow again if prices rise to, say, $60 per barrel — some analysts suggest an extra 300,000 barrels per day, others 900,000 barrels per day. “It’s a big uncertainty range,” he says.
Part of this is uncertainty about the “break even” point for many projects in the United States — the price at which it’s profitable to drill. During the price crash, many fracking companies managed to slash costs, but it’s often unclear how much of that was due to sustainable efficiency improvements and how much was due to unsustainable moves like squeezing suppliers or focusing only on the most productive wells (which they can’t do forever).
“The uncertainty about US shale is a huge game changer for OPEC,” Bordoff says. “If prices rise to $60, and a large volume of oil can come back quickly, that’s a very significant constraint on the ability of OPEC to manage the oil market that we haven’t seen before.”
The popular view of OPEC is that its members can sway the global oil market with a single utterance. We saw this in 2008, when prices were plummeting amid the financial crisis and OPEC stepped in to halt the slide. But OPEC doesn’t have the same power it used to. Over the past two years, the cartel has been paralyzed by indecision, watching as US shale drillers flood the market and swing global prices. Saudi Arabia and its allies are now trying to reassert its grip.
Further reading
— Why crude oil prices are always so tough to predict
— Here’s an in-depth look from earlier this year on why global oil prices have been falling ever since 2014.