Bank of Lithuania
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OPEC’s era of dominance in the global oil market is coming to a close. Having failed to push US oil producers out of the market, in the recent months the cartel has also been unsuccessful in trying to uplift the oil price level. This suggest an ongoing shift in the balance of power in the international oil market, rendering the perspective of prices returning to previous heights of more than USD 100 per barrel unlikely, at least in the immediate future.

Comment by Mindaugas Liutvinskas, Senior Economist at the Economic Policy Analysis Division of the Bank of Lithuania

At the end of November 2016, OPEC and a group of non-cartel states, including Russia, reached an agreement to curb oil production. The central aim of this agreement was to boost global oil prices, which have remained at relative low levels since mid-2014. The participating parties agreed on reducing oil production by 1.8 million barrels per day (mb/d), equivalent to around 2% global oil supply.

Despite the scope of this agreement, it has proven unsuccessful in pushing oil prices upward. In early December 2016 – immediately after signing the agreement – a barrel of Brent oil cost USD 54, while in the recent months prices have fluctuated in the rage of USD 46–52 per barrel. This is far from the heights recorded in the pre-2014 period, when prices settled significantly above USD 100 per barrel.

OPEC is itself partly to blame due to the limited price impact of the November agreement (extended in May 2017). Members of the cartel, as well as other participating states, have so far been unable to fully comply with the commitments undertaken. Latest available data indicates that the amount of oil production cuts is merely 78% of what was agreed on.

OPEC’s abilities to influence price levels are also limited by unusually large oil inventories stocked in the advanced economies, making them less dependent on supply-side changes, at least in the short run.

US shale oil producers inhibit price increases

Nevertheless, the critical reason behind OPEC increasingly losing its standing in the global oil market stems from structural changes on the supply side. A decision taken in 2014 not to reduce oil production despite falling oil prices (this strategy was followed until November 2016) led to oversupplied international markets, further depressing prices. Most likely, this strategy was aimed at pushing higher-cost producers – primarily US shale oil firms – out of the market.

Yet, differently from what was envisaged, the US shale oil industry managed to stay in the market by adjusting to the new low-cost environment. American firms operating in this sector reduced their operative costs significantly – by 25% on average. This means that US shale oil producers exploiting existing wells are able to continue drilling even with prices as low as USD 24–35 per barrel (WTI oil). For their investment into new wells to be profitable, oil prices should fluctuate between USD 46 and 53 per barrel.

Data indicates that oil production in the US has been increasing steadily in the recent years. The US Energy Information Administration (EIA) predicts that in 2018 total US oil production will reach 10 mb/d – the highest level since 1970. The bulk of this increase is expected to come from the American shale oil sector, currently accounting for 5.5 mb/d.

Therefore, despite OPEC’s efforts, global oil supply is not decreasing. On the contrary – it is showing signs of further expansion. This will probably create additional pressure for prices to stay at current levels, possibly even pushing them to further lows.

The ‘new normal’ in the oil markets?

OPEC still produces around one third of all oil consumed worldwide and enjoys low production costs. However, the adjustment of US shale oil producers to operate in a low-price environment means that the ability of the cartel to control market dynamics unilaterally has decreased substantially.

Looking into oil prices in the short-to-middle term, two baseline scenarios seem plausible. The low supply scenario suggests increased levels of compliance with production cuts in OPEC and other oil producing states, the possibility of more extensive agreements on limiting oil production, as well as supply shortages in countries characterised by high (geo)political risk. The high supply scenario is based on increasing levels of shale oil production in the US and weakening compliance rates in OPEC and non-OPEC oil producers.

Preliminary calculations suggest that in the first case oil prices could fluctuate in the range of USD 52–56 per barrel, while the second scenario implies prices steadying around USD 44–48 per barrel. Vast potential of further US shale oil expansion and a limited price impact of production cuts to date allow claiming that in 2017–2019 global oil prices should fluctuate in a range close to USD 50 per barrel (Brent, WTI and Dubai index).

Having settled down at this level, oil prices would correspond to the operative costs of US shale oil firms (necessary for profitable investment into new wells), while also representing their increased influence on the global oil market. Needless to say, there is always the risk that such forecasts will have to be adjusted due to some unexpected market shocks, such as new military conflicts in the Middle East.

In the longer run prices may rise again

Status quo in international oil markets will most likely have a positive impact on the world economy, benefiting oil-importing countries, such as Lithuania, disproportionally. Also, in the upcoming years oil prices should not create significant additional inflationary pressure. This may become one of the factors limiting the ability for major central banks worldwide to start implementing monetary policy normalisation.

Adding to this, a prolonged period of relatively low oil prices will negatively affect investment into exploration of new oil sources and the development of modern extraction technologies. The International Energy Agency (IEA) indicates that worldwide investment in the oil and gas sector fell by 44% in 2014–2016. In the longer run, reduced investment may become an important factor behind lagging oil supply, eventually pushing prices upward.