How countries can cope with oil’s second great upheaval

Without removing the glut and putting a stop to price discounting in the producers’ fight for market share, there will be no solution.

World oil production is at a record level with severe imbalance between supply and demand. Andrey Rudakov / Bloomberg
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The oil industry has managed to keep prices fairly stable for nearly a century. The "Seven Sisters" group made available, through concessions, the oil supplies needed to meet demand. There was rarely a shortage, even at times of war, and supplies were controlled to avoid a glut.

Since the creation of Opec in 1960 and the International Energy Agency in 1973, oil was no longer fully controlled by the Seven Sisters and became freely traded in international markets and hence subject to fluctuations, like other freely traded commodities.

Since the early ’70s, world oil prices have gone through two major upheavals. In the first, prices increased from US$2 to $40 per barrel. That made the development of the North Sea and Alaska oilfields economically feasible. It was followed by a collapse in the mid-80s to prices in the single digits.

The second upheaval, which we are still living through, started with a price boost linked to the financial crisis of 2008. After a hiccup, prices started falling in mid-2008, followed by a gradual increase approaching $150 per barrel. Then came a collapse starting mid-2014.

The second price escalation to unprecedented high levels helped to accelerate the development of costly unconven­tional oil and gas resources, including those from shale, oil sands and out of very deep waters. It is the contribution of these sources to the supply side of the equation that caused the accumulation of an oil surplus, leading to increased competition between suppliers and the price collapse.

Where are we now?

First, world oil production is at a record level with severe imbalance between supply and demand. Second, strategic and commercial oil stocks are at record levels in addition to huge volumes of unsold old production, which producers store afloat and on land outside their territories. Third, because of low prices and losses, investment in the sector has been reduced. Norway has cut oil sector investment by 30 per cent since 2014. It is expected that in 2025, British oil and gas production from the North Sea will be only half of what it is now, again because of low investment.

How do we get out of the impasse?

Without removing the glut and putting a stop to price discounting in the producers' fight for market share, there will be no solution. Last month, Russia and three Opec members – Saudi Arabia, Qatar and Venezuela – reached agreement in principle to freeze production at the level of January, which we assume is to allow time for: (1) a natural reduction in oilfield productivity as a result of natural depletion; (2) an increase in demand for oil because of the hoped for world economic recovery and increased population enjoying a better standard of living; and (3) a reduction of supplies as a result of closure of high-cost production facilities.

We understand the freeze proposal is to be discussed this month by Opec members, as well as Russia and a number of other producers.

A few observations are in order regarding a freeze:

Irrespective of how many producers participate in the freeze, natural production capacity decline will be the most important factor in reducing the gap between supply and demand.

Strict adherence to the rules will be of utmost importance. The production freeze scheme, being a modified version of the Opec production ceiling and quotas previously adopted by Opec as a measure to manage price levels, suffered from non-adherence, despite being monitored by an international accounting firm.

It will not be possible to make private investors participate in the scheme, but national oil companies would have to honour government commitments.

When the freeze starts, the first stage will have to be long to allow time to dispose of all production stored afloat and outside participants' terri­tory. Time is also needed for the natural depletion of producing fields, reducing their production capacity as well as closure of losing ventures. Some uneconomic operations might con­tinue producing thanks to government financial support for strategic reasons and to keep skilled labour, especially when most of the cost is in local currency.

Several Opec officials have mentioned that the production freeze is only a start to be followed by other measures, the nature of which will depend on the results achieved in the freeze phase. They also talk of high, low or fair prices but never mention the numbers they have in mind.

Hopefully, for some, additional contribution from global economic recovery boosting demand will help to shorten the time required for the freeze to succeed.

The drastic reduction in investment in the oil sector since the start of this price collapse will be the major element to return us to balanced markets. This will be mainly because less oil will be pumped from old fields and no new capacities will come into global production.

Once we reach a balanced market, increased demand because of population growth and world economic recovery will support prices. Higher prices will also bring back into play some mothballed capacities, but it will also encourage cheating on the freeze. This will cause prices to fluctuate for a long period.

The cost of oil and energy alter­natives developed during the high price period will set, for many years to come, the price ceiling for crude oil in the free markets. Sooner or later, time heals all wounds.

Ramzi Salman was an adviser to Qatar’s minister of energy and industry. He has also been deputy secretary general of Opec and chief executive of Iraq’s State Oil Marketing Organisation.

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