OPEC was formed in the 1970s and the cartel could control prices - because the global economy runs on oil, and bulk of the reserves were in the Middle East.
They figured out, Oil Demand is inelastic. People have to buy no matter what price. It’s the most dense form of energy.
They figured out, Oil Demand is inelastic. People have to buy no matter what price. It’s the most dense form of energy.
Price Elasticity if Demand in the short run was 8x.
1% cut in Oil production would lead to 8% rise in price.
But if prices are too high, then people start saving energy and demand falls.
1% cut in Oil production would lead to 8% rise in price.
But if prices are too high, then people start saving energy and demand falls.
For an oil producer - the key is to Maximize the Revenue.
Not just this year, but sustainably for a long time.
So bringing a lot of production offline , you wouldn’t sell much.
You need Max(volume x marginal Profit/ unit)
Not just this year, but sustainably for a long time.
So bringing a lot of production offline , you wouldn’t sell much.
You need Max(volume x marginal Profit/ unit)
OPEC was formed by Middle eastern countries, (later Venezuela and Nigeria joined).
The cartel would decide an optimum level of production - so as to maximize the profit of the group.
In 1970s Texas oil fields and later 80s 90s Dutch and English North Sea oil wells were drying
The cartel would decide an optimum level of production - so as to maximize the profit of the group.
In 1970s Texas oil fields and later 80s 90s Dutch and English North Sea oil wells were drying
This gave the Monopoly power to all the Cartel Members.
But if you are a member of the cartel, and everyone else reduces production, and you sneakily produce 5-10% more than your quota ... you benefit the high price, while others reduce production.
Cheating is very profitable
But if you are a member of the cartel, and everyone else reduces production, and you sneakily produce 5-10% more than your quota ... you benefit the high price, while others reduce production.
Cheating is very profitable
This also called ‘Tragedy of the Commons’ or ‘Prisoners Dilemma’ in #GameTheory
If everyone cooperates, you all make good money.
If I cheat, but others cooperate, I make higher profit.
If everyone cheats, everyone produces more then oil prices crash. No one makes big money.
If everyone cooperates, you all make good money.
If I cheat, but others cooperate, I make higher profit.
If everyone cheats, everyone produces more then oil prices crash. No one makes big money.
How to ensure that everyone is in line?
Here Saudi Arabia played the role of enforcer or Big Brother.
OPEC controlled 40% of global oil production.
Saudi controlled 12% (30% of OPEC)
If Saudi felt anyone is cheating, it would open the taps, and pump a lot more.
Here Saudi Arabia played the role of enforcer or Big Brother.
OPEC controlled 40% of global oil production.
Saudi controlled 12% (30% of OPEC)
If Saudi felt anyone is cheating, it would open the taps, and pump a lot more.
This would inflect pain on all the other oil producers. And hence cartel members would fall in line.
This was the way to enforce discipline.
This was the way to enforce discipline.
Meanwhile why did OPEC have so much influence.
Because they had the luxury not to drill for oil, as they had small population and large oil reserves.
If price is too low, just store the commodity (what’s better than let it stay under ground) and pump out when it’s valuable
Because they had the luxury not to drill for oil, as they had small population and large oil reserves.
If price is too low, just store the commodity (what’s better than let it stay under ground) and pump out when it’s valuable
Middle East also priced Oil in USD.
If international trade was in US dollars then everyone needs reserves of USD for buying oil
Nixon and Kissinger also ensured that Surplus from oil would remain in USD and invested in US debt.
This was rise of #PetroDollars
If international trade was in US dollars then everyone needs reserves of USD for buying oil
Nixon and Kissinger also ensured that Surplus from oil would remain in USD and invested in US debt.
This was rise of #PetroDollars
Why couldn’t other oil producing nations control production at their whim and fancy?
Why couldn’t they cease drilling?
Because they consumed more than what they produced. And lot of production was private companies wanting to maximize profits for next quarter.
Why couldn’t they cease drilling?
Because they consumed more than what they produced. And lot of production was private companies wanting to maximize profits for next quarter.
Thus OPEC had a monopoly on oil.
Briefly Russians tried to break it, but in 1985 with US support, Saudis flooded the market with oil, that hastened the collapse of USSR. (Atleast a major contributor)
In 1991 gulf war saw oil price spiral higher and recession in US
Briefly Russians tried to break it, but in 1985 with US support, Saudis flooded the market with oil, that hastened the collapse of USSR. (Atleast a major contributor)
In 1991 gulf war saw oil price spiral higher and recession in US
But in late 90s production of oil was in surplus.
After Asian financial crisis in 1997, global demand plummeted, this time Saudi continued pumping and in 1998 low oil prices lead Russia defaulting on its debt.
After Asian financial crisis in 1997, global demand plummeted, this time Saudi continued pumping and in 1998 low oil prices lead Russia defaulting on its debt.
Fast forward to 2014
US develops a technology called Hydraulic Fracturing (fracking) which can drill out oil from places where earlier it wasn’t possible.
Canada has tar sands, from where it can drill out oil.
In the last 6 years US is self sufficient in oil
US develops a technology called Hydraulic Fracturing (fracking) which can drill out oil from places where earlier it wasn’t possible.
Canada has tar sands, from where it can drill out oil.
In the last 6 years US is self sufficient in oil
It still imports some crude as refineries are value rates to different grade of crude from what its drilling. But net import and export of crude oil + distillates is zero.
These oil wells aren’t particularly owned by the state or even large oil majors like Exxon, Chevron, Shell or BP.
These are wildcatter businessmen who have drilled using experimentation, and their learning curve has seen Marginal Cost of production drop to ~40$/bbl from 60+
These are wildcatter businessmen who have drilled using experimentation, and their learning curve has seen Marginal Cost of production drop to ~40$/bbl from 60+
This increased supply saw crash in oil prices in 2015. (Along with more use of renewables, post crisis frugality and environmental concerns)
Again the OPEC got Russia to join them to form OPEC+
Cartel is bigger, controlled and got back prices to 60-80 $/bbl
Again the OPEC got Russia to join them to form OPEC+
Cartel is bigger, controlled and got back prices to 60-80 $/bbl
But from 2018 there is US China Trade war, and anyways China is slowing down and oil demand isn’t growing from the new biggest customer.
China is also getting big on electric vehicles to reduce urban pollution.
Buy OPEC+ is the new bigger cartel and prices are managed.
China is also getting big on electric vehicles to reduce urban pollution.
Buy OPEC+ is the new bigger cartel and prices are managed.
Late 2019 #Covid19 strikes in Wuhan and early 2020 it spreads everywhere.
With whole cities in lockdown, people working from home, kids attending classes online, less people driving or consuming goods.
Oil demand crashes.
With whole cities in lockdown, people working from home, kids attending classes online, less people driving or consuming goods.
Oil demand crashes.
This sees fall in crude oil prices from $65 to 45.
OPEC+ meets, and want to cut production but can’t reach an agreement.
Saudi wants 1.5mln barrels a day cut.
Russia wants 0.6 to 1mln a day.
(World consumption is 90-100bbl day, US is biggest producer and consumer at 18)
OPEC+ meets, and want to cut production but can’t reach an agreement.
Saudi wants 1.5mln barrels a day cut.
Russia wants 0.6 to 1mln a day.
(World consumption is 90-100bbl day, US is biggest producer and consumer at 18)
Saudi gets infuriated, and plays the Tit-for-tat game again and says instead of rescuing they will increase production.
This would hurt other oil producers.
(USA and Russia being the biggest)
Now this was the movie so far.
What happens next?
This would hurt other oil producers.
(USA and Russia being the biggest)
Now this was the movie so far.
What happens next?
1. Saudis don’t have a budget surplus any more. They actually need a high oil price to sustain the social spending on a large population. They are borrowing from the bond markets to fill the deficit.
But they have been comfortably borrowing a lot more money from global investor
But they have been comfortably borrowing a lot more money from global investor
2. Russia has geopolitical ambitions in Syria (anti Saudi) and pro Iran. Hence did they deliberately not agree to cooperate?
But they do have other exports (defense goods, agri products, engineering capital goods)
And tourism.
Also has a floating currency.
But they do have other exports (defense goods, agri products, engineering capital goods)
And tourism.
Also has a floating currency.
Due to weaker oil prices, its currency would be weaker and help other industries like tourism.
I too went to Russia (Moscow and St. Petersburg) on vacation.
I too went to Russia (Moscow and St. Petersburg) on vacation.
3. USA - has a diversified oil industry.
Non of the shale drillers are too big to save.
Lot of them are financed by High Yield bonds and loans.
Even if they default, investors have been through crisis before.
Employees fired is a common thing.
If one driller goes bust
Non of the shale drillers are too big to save.
Lot of them are financed by High Yield bonds and loans.
Even if they default, investors have been through crisis before.
Employees fired is a common thing.
If one driller goes bust
Oil is still under the ground and technology exists to take it out later. Pain will be acute but distributed.
New firm takes over bankrupt firm and drills again.
New firm takes over bankrupt firm and drills again.
This is unlike Venezuela (country with biggest oil reserves) which has a lot of oil, but doesn’t have money or resources to take it out
Due to sanctions by USA and mismanagement.
So in this high stakes Gamble 3 big players are USA, Russia and Saudi.
Saudi raised the stakes, forcing others to spend more (or borrow to continue drilling) - profits would come when prices might rise in the future
Saudi raised the stakes, forcing others to spend more (or borrow to continue drilling) - profits would come when prices might rise in the future
Just like high stakes poker (or any gambling) one with longer staying power wins.
Who can survive pain longer wins.
But here - it’s not so sure that as soon as this period of low prices is done, some one flips off a switch and others can’t start drilling.
Who can survive pain longer wins.
But here - it’s not so sure that as soon as this period of low prices is done, some one flips off a switch and others can’t start drilling.
People might not lend a bankrupt country (Venezuela) or Russia immediately post 1998.
But in USA capitalism works.
File chapter 11, get fresh capital and new management.
Same employees can start drilling.
But in USA capitalism works.
File chapter 11, get fresh capital and new management.
Same employees can start drilling.
Anyways - there is a lot of collateral damage.
Lower oil prices hits smaller exporters - Nigeria, Mexico, Malaysia
Hits global trade (double whammy due to corona virus)
Lower oil prices hits smaller exporters - Nigeria, Mexico, Malaysia
Hits global trade (double whammy due to corona virus)
With falling prices, inflation expectations are reduced or deflationary expectations rise.
This makes nominal growth lower and people are used to the rut.
This makes nominal growth lower and people are used to the rut.
I personally think Saudi in 2020 is very different from 1985 or 1998.
Let’s see who emerges a winner.
Let’s see who emerges a winner.
For more - read wonderful article by @davidfickling
And read his entire thread (if you aren’t bored of my rambling already)
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