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Market Focus: Squaring the OPEC+ circle

OPEC+ failed to reach an agreement on raising crude supplies at it latest meeting. The most contentious issue was the baseline to calculate potential individual contributions be considered for an extension of the OPEC+ agreement beyond April 2022. OPEC+ agreed last year to cut output by almost 10 million barrels per day from May 2020, with plans to phase out the curbs by the end of April 2022. Cuts now stand at about 5.8 million barrels per day. As reported by Reuters, OPEC+ “voted on Friday to raise output by some 2 million barrels per day from August to December 2021 and to extend remaining cuts to the end of 2022, but UAE objections prevented agreement”. The UAE, which managed to increase its production capabilities unsuccessfully asked the coalition to revise upward its own production baseline in order to accept the extension of the production cuts in 2022. This would have de facto translated into a quota waiver and into a weakening of the established allocation structure for individual contributions. As usual in the case of “OPEC and Friends”, it is important to understand behind-the-scene negotiations and the bargaining process in order to fully grasp the significance of the latest move.

OPEC+ failed to reach an agreement on raising crude supplies at it latest meeting. The most contentious issue was the baseline to calculate potential individual contributions be considered for an extension of the OPEC+ agreement beyond April 2022. OPEC+ agreed last year to cut output by almost 10 million barrels per day from May 2020, with plans to phase out the curbs by the end of April 2022. Cuts now stand at about 5.8 million barrels per day. As reported by Reuters, OPEC+ "voted on Friday to raise output by some 2 million barrels per day from August to December 2021 and to extend remaining cuts to the end of 2022, but UAE objections prevented agreement".

The UAE, which managed as of late to increase its production capabilities, unsuccessfully asked the group to revise upward its assigned production baseline - or quota - in order to accept the extension of the production cuts in 2022. This would have de facto translated into a quota waiver and would have destabilised the established allocation structure of production cuts that has been achieved for all the individual members of the coalition in May 2020. As usual in the case of "OPEC and Friends", it is important to understand the behind-the-scene calculations and both the economic and non economic factors involved in the bargaining process in order to fully grasp the significance of the latest move.

For a handful of barrels

OPEC crude oil production in May was up by 0.39 mb/d m-o-m to average 25.46 mb/d. Non-OPEC liquids output including OPEC NGLs in May was up by 0.24 mb/d m-o-m to average 68.21 mb/d, a rise of 4.30 mb/d, y-o-y. As a result, world oil supply is estimated to have grown m-o-m in May 2021 by 0.63 mb/d to average 93.67 mb/d, up by 5.63 mb/d y-o-y.

At stake is the sharing of the additional oil rent extracted from the recovery of the global demand for oil in 2021 and most importantly in 2022. According to the latest OPEC projections, oil demand is expected to recover back to its pre-pandemic level (~100 mb/d) only by Q4 2021. According to the same projections, which serve as a basis for negotiations within the group - although each country may also drag its own forecasts and projections into the discussion - the bulk of additional oil demand in 2022 would come from China, from the United States and to a lesser extent from India. These three major oil markets can source oil outside the realm of the OPEC+ agreement. In the United States, this could be easily achieved by boosting the output of the shale oil industry, despite the likely protests from environmentally friendly groups and the "pro-climate" bias of the Biden administration. China and India can also boost their oil supplies from Iran, Venezuela and Libya. These three major oil-producing countries are OPEC members but they are currently exempt from the OPEC+ agreement.

Overall, this shows that OPEC+ has a shaky control over global supply dynamics going forward, especially given the diverging views within the coalition and the differences in the structure of the domestic oil sectors - for example between Russia, which boasts a range of state-owned and private producers, and Saudi Arabia, where the 99% state-owned Saudi Aramco enjoys a de facto monopoly over oil extraction. In turn this translates into diverging long term strategic objectives and political priorities.

From Game of thrones to Game theory

By the end of 2021, the OPEC+ agreement would cease to be justified from a short term market regulation perspective. However, it could still be justified from a strategic long term perspective. Indeed, the looming challenge for oil producing countries is to optimise the rent extracted from these fossil ressources before global oil demand declines, as the largest consumer markets accelerate their transition toward carbon neutrality.

For that to happen, OPEC+ needs to transform itself into a rejuvenated OPEC that would have to manage the challenges associated with "peak oil demand" and carbon pricing, while fulfilling its role of balancing global oil supply and demand for the primary benefit of its members. Admitting Russia to OPEC, provided the Russian government would really consider this option, would turn it into a bicephalous organisation with two supersized members contending for leadership within the block, while being forced to cooperate with each other and to devote energy and diplomatic ressources to achieve and to maintain a broad-based consensus. Over the last decades, Saudi Arabia has acted unilaterally at several occasions when it considered that this would better fit its national interest. It is difficult to see how a double-headed organisation could better be able to preserve a unified front.

In such a scenario, the influence of intermediate oil powers like the UAE, Iran and Iraq is poised to grow, as they would act as power brokers and ultimate decision makers within the organisation. It will therefore be critical to find a middle ground between their requests and the necessity to maintain the group's cohesion. Knowing that, the UAE has perhaps thought the time has come to "test its hand" with its latest move, at the risk of breaking havoc the fragile OPEC+ scaffolding.

There are however peaceful ways to resolve this oil-related "Game of thrones". Indeed, there is no need to send modern-time dragons (i.e. fighter jets and bomb carriers) to push the Spartan oil-rich Abu Dhabi emirate and its Corinthian sister-emirate Dubai to capitulate.

OPEC and for that matter OPEC+ might be treated within a classical framework of microeconomics enhanced with game theory. As Robert Pindyck wrote in a seminal 1978 paper (Gains to Producers from the Cartelization of Exhaustible Resources): "The problem of measuring the potential gain from the cartelization of a particular exhaustible resource can be put quite simply. Given reserve levels and the dynamic structure of demand and cost, and given that the objective of each producer is to maximize the sum over time of discounted profits, what are the optimal price trajectories under competition and under cartelization, and how much larger is the sum of discounted profits as a result of cartelization?".

Under both the cartelization and competitive scenarios, this is akin to finding a solution to a problem of intertemporal profit optimization taking into account a few constraints, such as the exhaustible character of the ressources - which could be accounted for through an increasing marginal extraction cost function - the existence of substitutes - which puts a downward pressure on marginal profits to be earned in the future. The discount rate is a key variable in the competitive case as it pushes ceteris paribus oil producers to maximize their profit earlier whenever it is high, while low discount rates warrant a more "conservationist" ("no rush") behaviour. Harold Hotelling theorized this idea in a 1931 article under what has since become known as Hotelling's rule. In practice, large deviations from Hotelling's rule have been observed in oil prices.

The creation of OPEC might be one of the factors explaining these deviations and the so-called "Hotelling puzzle". The benefits from cartelization can be analyzed in the first instance as a super profit earned from colluding and producing below what would be produced in a competitive setting. But there is an overwhelming historical evidence shows, including the latest failure to reach a deal, indicating that OPEC - and for that matter OPEC+ - is quite an imperfect cartel. In a paper published in 2014, Samuel Okullo and Frederic Reynes argue that OPEC's "imperfect collusion arises because the cartel has to balance both internal and external interests. Balancing internal interests means that the cartel has to assign quotas in a manner that would not cause some members to exit the arrangement. This as indicated requires giving larger production quotas than would be implied by effective collusion, more especially to smaller producers. To balance external interests, OPEC has to ensure that its production is large enough so as to crowd out non-OPEC supply that thrives under situations of high prices."


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