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OPEC Looks Doomed, And This Is How It Happened

I don’t know about you, but I’m loving these low gas prices.

As of Tuesday, the national average gasoline price stood at $2.26 per gallon. That’s about one dollar less than prices from the same time last year, according to AAA Fuel Gauge. Gas has rebounded in recent weeks because of higher oil prices, refinery maintenance and union strikes, but the low prices are part of a much larger story playing out right now — a story that could mean the end of OPEC as we know it.

How did the world get to such a place? A shale boom, miscalculation by OPEC, and a realignment of oil prices seem poised to forever change the way oil business is done. Regardless of how the oil price plunge plays itself out, it’s sent a chilling message to OPEC member states.

Bottom line: The international oil cartel won’t be able to wield the same influence over oil markets as it has in the past.

Setting Up The Glut

Oil prices skyrocketed from about 2002 to 2008 when the recession hit, rising from an average of $26 per barrel to a whopping $99 per barrel in 2008 on the West Texas Intermediate (WTI) crude oil price benchmark. Europe’s Brent crude oil price index saw a similar rise during that time, from $24 per barrel to $97 per barrel, before the recession hit.

The 2008-2009 recession caused WTI and Brent oil price benchmarks to fall, but both indexes had more than recovered by 2010. By 2013, WTI’s benchmark price was at $98 per barrel and the Brent crude price was at $108 per barrel.

The effects on the demand side were predictably dismal, hitting consumers hard. Higher energy costs rippled throughout the economy and contributed to price spikes across a myriad of consumer products. That sucked, but inside the high oil prices were the seeds of an eventual price collapse. Perhaps more importantly, the high prices — around $100 per barrel — made it economical for U.S. oil companies to extract oil from shale formations using innovative techniques, like hydraulic fracturing, or fracking, and horizontal drilling.

The innovations unleashed a U.S. oil boom.

Oil production grew from 5.5 million barrels per day in 2008 to 7.4 million in 2013. And it didn’t stop there — in November 2014, U.S. oil production was more than 9 million barrels per day.

Fracking not only revitalized local economies (a welcomed change), but it also meant the U.S. was importing far fewer barrels of oil from abroad, particularly from Africa. In fact, North America as a whole was seeing an energy boom. High oil prices allowed Canada to frack and extract oil sands from northern Alberta. America’s northern neighbor went from producing 3.3 million barrels per day in 2009 to more than 4 million barrels per day in 2013.

Booming North American oil production cut into U.S. imports of foreign oil and put more product on the international scene. This shift in reliance coupled with weaker economic growth in once booming economies like China. And what happens when supply outstrips demand? That’s right, the price goes down.

In this case the price went into the basement. The Brent crude price plummeted from $111 per barrel in July 2014 to $48 per barrel in January 2015. Over that same time frame, the WTI price collapsed from $105 t0 $47 per barrel.

What Would OPEC Do?

As prices fell, lots of market players, speculators and experts thought OPEC, the world’s oil cartel, would put a stop to the collapse by cutting production like they usually do — but that didn’t happen.

Over the Thanksgiving holiday last year, OPEC announced it would not be cutting back production, shocking markets and causing oil prices to fall even further.

OPEC’s decision to not cut production and raise prices was a shock to observers, because it hurt their own member states. Iran and Venezuela were begging Saudi Arabia to back production cuts because their finances were being heavily impacted. In fact, many OPEC members were seeing export revenues wither away as oil prices plunged.

So why did the Saudis — OPEC’s top oil producer and control lever — not scale back production?

From Arabia With Love

The Russians have argued it’s a plot by the Saudis and the U.S. to punish Vladimir Putin for invading Ukraine. Russia is the world’s second-largest oil producer and relies on high prices to fund much of its government. Russia’s finance minister says their budget was taking a $180 billion hit because of falling oil prices.

Russia, like many OPEC members, is having to take money from its sovereign wealth fund to buoy its budget until oil prices recover.

“The economic pressure isn’t expected to change Putin’s aggressive efforts to retain strong influence over Ukraine, which he considers non-negotiable,” notes Los Angeles Times writer Paul Richter. “But they are causing strains in his relations with the Russian elite and business establishment, two pillars of his political support.”

Keeping The Kids In Line

But in hurting Russia, Saudi Arabia would also be hurting OPEC. Some observers have said that’s exactly what they want.

One has to remember that OPEC, while a cartel, is still made up of individual member states, so any production cuts will be shouldered by individual countries. This can create a kind of collective action problem, because there’s a disincentive for members to cut production and lose market share.

So Saudi Arabia could be letting prices collapse so less efficient OPEC producers like Iran, Nigeria, Ecuador and Venezuela will be forced to cut their own production, so the Saudis don’t have to shoulder the burden alone.

Punishing Iran is another possible motive for Saudi Arabia’s decision not to cut prices. Iran was begging the Kingdom to back production cuts to raise prices. With oil prices well below $100 per barrel, Iran’s finances have crumbled — and this is on top of the Western economic sanctions over their nuclear program.

There’s also the religious angle: the Saudi regime is Wahhabist, a hardline Sunni Muslim movement, and the Iranians are Shiite. Needless to say these two regional powers don’t get along too well. Keeping oil prices low is one way the Saudis can hurt Iran for its nuclear ambitions.

Economic War Against The U.S.?

Feuds with OPEC members and Russia aside, could the Saudis real target be booming U.S. oil production?

OPEC controls 81 percent of the world’s oil reserves, 66 percent of which are in the Middle East. Saudi Arabia has historically been the world’s largest oil producer, but the U.S. overtook the Kingdom as the world’s top producer thanks to the shale boom.

It’s North American oil production that helped drive down world prices, so it’s that production the Saudis are targeting. The calculus is that because Middle Eastern oil is less costly to extract than North American shale and oil sands, a price plunge will make the latter less economical and production will have to be cut back.

“Why did the Saudis choose this road? Their logic seems convincing,” writes Leonardo Maugeri, a senior associate at the Belfer Center for Science and International Relations of Harvard’s John F. Kennedy School of Government.

“By leaving the market uncontrolled, prices could only drop, because of excess production,” Maugeri writes. “However, part of this production would be too costly to survive low prices, and would therefore disappear. The Saudis were certain that it would not take much, and that the first to feel the impact of this strategy would be the US, Canada, and other countries who in recent years have seen their production increase rapidly thanks to the high price of petroleum.”

There’s just one problem: technology and efficiency improvements have made North American oil production much less expensive than the Saudis initially predicted. U.S. shale oil producers can still produce with oil prices at $40 to $45 per barrel and Canadian oil sands will still be taken out of the ground with prices at $30 to $35 per barrel.

U.S. shale producers can stay in business by concentrating on their most profitable wells and cutting back in other areas — some of these wells can even stay profitable at $35 per barrel. On top of this, drilling technology is constantly getting better and driving costs down for oil companies.

Don’t get me wrong, there are oil companies hurting and people are losing their jobs. Low oil prices are good for the broader economy, but can be painful for the oil industry.

“The real focus will be on more survival plans for 2015—how they plan to operate in this environment,” Daniel Katzenberg, an analyst at Robert W. Baird & Co, told the Wall Street Journal. “It will come down to who has…better break-even costs, and who has the better balance sheet so that you can be confident they will survive.”

But OPEC is being hurt as well. One estimate found OPEC members will lose $375 billion if oil prices stay under $70 per barrel. Like Russia, Saudi Arabia is having to dig into its sovereign wealth fund to plug its growing budget deficits.

What’s On The Horizon?

Oil prices will go up eventually, the question is just how much they’ll go up. The International Energy Agency said the U.S. energy boom, and low prices, could stick around for a while — all the way to 2020.

“This unusual response to lower prices is just one more example of how shale oil has changed the market,” said IEA Executive Director Maria van der Hoeven. “OPEC’s move to let the market rebalance itself is a reflection of that fact.”

The U.S. Energy Information Agency predicts that oil prices will average between $71 and $75 per barrel by 2016 as supply is cut and demand rises. But EIA also notes that U.S. crude oil production will grow to a whopping 9.5 million barrels per day by that time as well, which could put some downward pressure on world prices.

On the other hand, OPEC says oil will rebound to $200 per barrel over the next few years after low prices shuts in North American production and drives demand back to OPEC member states.

“There are strong indications that U.S. shale producers are taking a hit, and by the second half of this year a lot of marginal barrels will disappear from the market and demand will rise for OPEC members,” an OPEC official told the Wall Street Journal.

Whatever happens to oil prices one thing is clear: U.S. shale production has changed the way OPEC operates.

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