In April, the Organization of the Petroleum Exporting Countries (OPEC) agreed to its biggest production cut in history: 9.7 million barrels of oil a day (mb/d). OPEC, which is celebrating 60 years in September, is confronting its toughest challenges: in the short-run, it has to deal with a drastic demand reduction in light of the Covid-19 pandemic; in the medium- and long-run, an accelerating energy transition that is reducing the value (and social desirability) of oil as a source of energy.
Together, they point to key challenges facing OPEC members: exploiting their abundant reserves before the age of oil is over, while managing declining revenues and geopolitical power.
As of 2020, fossil fuels still dominate the world energy matrix: oil (32 percent), coal (26 percent), and gas (23 percent) are the major sources of primary energy to the world. However, they serve different markets. Gas and coal are mostly used to generate electrical energy, with many competing sources (hydro, nuclear, solar). On the other hand, oil is the king in transportation (with a 94 percent market share) thanks to its high energy density, ease of storage and a legacy infrastructure built around this industry from cars and trucks based on internal combustion engine technology to universally available pump stations. This legacy is part of what American business professor Gregory Unruh called carbon lock-in: systematic forces that perpetuate fossil fuel-based infrastructure and their political support.
To break out of a lock-in and expand alternative sources requires an external shock, claim Michaël Aklin and Johannes Urpelainen in their book “Renewables: The Politics of a Global Energy Transition” (MIT Press, 2018). A global shock to the oil industry is exactly what Covid-19 may be providing. What made the pandemic particularly painful to the oil industry was its generalized effect on mobility: stay-at-home policies and closed borders means not driving to work, and not flying for business trips and tourism. The International Energy Agency (IEA), itself created as the Western response to OPEC after the first oil shock (1973), forecasted in its May report a global reduction of oil demand by 8.6 mb/d in 2020, roughly 9 percent, the sharpest drop ever. Rystad Energy, an oil data service provider, predicts an ever sharper decline of 11 percent for the year.
The sudden demand reduction was not followed by proportional cuts in supply at the same pace. Unlike an industry of conveyor belts, where production can easily be stopped by pulling a chord, oil is extracted from wells where reservoir pressure needs to be carefully managed. Besides, deciding production cuts by a political mechanism (such as OPEC meetings) always involve a delicate coordination problem within all oil producers. With oil flowing from wells to pipelines but not demanded by consumers, storage capacity reached its limit. On April 20, the WTI contract, a reference of the US market, was traded at -$37 per barrel one had to pay others to accept oil cargoes. While negative prices may never repeat and figure as an odd thing from the year of the pandemic, which was also caused by the way the NYMEX WTI futures are traded, low oil prices are more likely to continue. There has been a fundamental change in both demand and supply in the industry and, for the first time ever, OPEC countries may prefer to accelerate their rate of extraction while they can.
The birth of a powerful organization and market competitors
In Baghdad, a conference in September1960 gathered leaders from Iran, Iraq, Kuwait, Saudi Arabia and Venezuela with the aim of creating an organization to assert their sovereign rights over natural resources against the international oil companies. Soon, other oil-rich countries would join the group. The post-war world economy was booming while Western oil production was unable to meet the rising demand. The bargaining power gradually shifted towards oil-exporting nations and OPEC would help them coordinate their contractual renegotiations with the international oil companies. Oil-rich nations progressively increased their share in the total profits from oil sales and, in many cases, went for a full takeover of industries by nationalizations. The Yom Kippur War (1973) accelerated this clash between the interests of oil states and large consumer markets, representing a transfer of wealth to the former by deploying “the oil weapon.” As explained by an Arab oil minister, the oil embargo and sudden price increases that characterized the first OPEC oil shock was an opportunity to make money and be a patriot at the same time.
Making too much money can bring its own problems to a cartel of producers: it invites competition. Alternative energies (biofuels, wind, solar), or synthetic fuels (coal-to-liquids), while technically substitutes, were not cost-effective sources with the technologies of the time. Nuclear, which had some boost and was an effective way to generate electricity on a large scale, faced its own security and environmental limitations, particularly after the Three Mile Island and Chernobyl accidents. Furthermore, it could not solve the demand for liquid fuels for transportation.
More significant competition came from oil production from non-OPEC areas. Economic theory expects production to continue until marginal cost equals price. However, in the oil sector, given government ownership of resources, areas with very low cost of production can cut back their output or limit the investment in productive capacity in order to receive more from each unit sold as a cartel such as OPEC will try to do. The consequence is that areas with higher costs in the world are developed before low-cost areas from OPEC countries are depleted. In the late 1970s, countries such as Iran, Iraq and Saudi Arabia had a production cost of about or less than $1, while Norway and the United Kingdom were between $10 and $15.
It would not normally be good business to enter in a market with a cost structure so much higher than your main competitors. However, the sudden price jump and nationalizations encouraged oil companies to venture to high-cost frontier areas, investing in new technologies to extract oil from the North Sea, Alaska and Gulf of Mexico. Even Brazil’s Petrobras saw in the country’s oil dependence, together with its offshore potential, a reason to invest in a long-term technological program starting in the late 1970s, to master deep offshore production systems. The company progressively scored goals in finding and developing new fields and, decades later, became a world leader in deep offshore oil production.
Non-OPEC oil flooded the markets in the 1980s. OPEC tried to sustain prices by cutting their own production, but by doing so, member countries were giving away market share to non-OPEC producers. Saudi Arabia did most of the cuts, going from over 10 mb/d in 1981 to a low of 3.6 mb/d in 1985, until it gave up and opened the spigots. OPEC share in the total world supply had gone from about half, in 1977, to only 27.2 percent in 1985. With Saudi Arabia pumping more oil after 1985, OPEC regained market share to around 40 percent in subsequent years. However, from 1986 to 2003, historical prices stayed below $30 per barrel, leading to a long period of low investments in new technologies and frontier areas outside the low-cost OPEC areas.
Starting in 2004, commodities prices boomed with a growing world economy and the rapid rise of China. Oil prices reached and stayed above $100 for years, and OPEC countries were happy to ride in another period of abundant revenues, this time driven not by an embargo or a revolution, but the simple fact that demand was growing faster than supply. As it happened again, this price signal created an incentive for another round of innovations, unlocking resources in oil sands, ultra-deep offshore and, of particular impact, vast shale resources in the United States. These unconventional resources require constant drilling, plus hydraulic fracturing, and have a much higher production cost than conventional, giant fields from the Middle East. This meant that, per barrel sold, companies that extract oil from unconventional sources have a much lower rent than those operating in most OPEC countries. In 2014, the year that United States surpassed Saudi Arabia in crude oil production, the average production cost of an oil barrel from the US was $72, while in Saudi Arabia was just $7.50.
Oil prices collapsed in 2014 following Saudi Arabia’s decision to regain market share from shale by increasing output to reduce prices in an attempt to kill the high-cost competitors. The strategy largely failed as US oil companies showed to be much more resilient, although not without major financial losses. For the most part, shale companies managed to bring production costs down enough to keep pumping and, surprisingly, the US became a net crude oil exporter.
Fundamental changes in the energy demand profile and technological gains in energy generated by solar, wind and also battery technologies (for storage) are casting a shadow over the future of the black gold industry
At the beginning of 2020, industry analysts were forecasting another year of faster oil production growth from non-OPEC countries. The cartel group had always to walk a fine line between restricting output too much (which encourages oil-to-oil competition and substitutes) and producing too fast, which would bring prices down and accelerate reserve depletion. At the current rate of extraction, technology and price, OPEC members have enough reserves to sustain 86 years of oil production, while non-OPEC nations much less, just 24. With abundant reserves at low production costs, they are in the oil business for the long-run, but the oil business might not be running for that long. Fundamental changes in the energy demand profile and technological gains in energy generated by solar, wind and also battery technologies (for storage) are casting a shadow over the future of the black gold industry, and the nations that fought so hard to control their natural resources.
Less oil, more (renewable) electricity
In the last decade, a common sight in many cities around the world has been solar panels on commercial and residential rooftops. Driving along a road, it may not be rare to find a solar or wind farm in many parts of the world. Flying or sailing, the sight may be caught by a floating solar system or an offshore wind production installation. The energy transition is underway and is becoming more widespread, visible and driven by economics and not policy subsidies alone, as was the case years before. Measured on a levelized cost of energy (LCOE) basis, new investments in solar and wind are already cheaper than coal and natural gas. Auctions around the world has been showing, with prices below $0.05/kWh.
Mobility is also changing. There are more than five million electric vehicles (EVs) on the road and, as charging infrastructure expands, the faster will be the penetration of EVs (it benefits from network externalities). All leading automobile manufacturers are investing heavily in EVs as core products of their future models, no longer just for niche markets. IEA, in one of their main (but not most ambitious) scenarios of the Global EV Outlook 2019, forecasts a stock of 130 million electric vehicles by 2030, reducing total demand for crude oil by 2.5 million barrels per day. This is equivalent to the oil production of Kuwait.
Solar photovoltaics and wind generation, although very cost competitive when measured on a LCOE basis, still suffer from intermittency: they do not generate when the sun is not shining or the wind not blowing. Because of that, energy systems require dispatchable sources to balance the grid (such as peak generators) or further cost reductions in storage solutions, like utility-scale batteries or pump-hydro. For that problem, the widespread expansion of EVs can be a game changer as well. EVs are, to a large extent, batteries on wheels, and the battery system alone can be 30 percent of the cost of a car. By absorbing electricity from the grid when renewables are generating at top capacity (and instantaneous prices can provide the right market signals to charge at that time), it can further facilitate the expansion of renewables.
This combination of increasingly cheaper cost of generating electricity from renewables and the expansion of electric vehicles is an enormous threat to the oil industry.
This combination of increasingly cheaper cost of generating electricity from renewables and the expansion of EVs is an enormous threat to the oil industry. A 2019 study by Mark Lewis from BNP Paribas (“Wells, Wires, and Wheels…”) calculates that the economics of oil will not be able to compete with renewables and electric vehicles in terms of mobility. EVs are much more efficient in converting electrical energy into mechanical power and also have lower maintenance costs (because of a reduced number of moving parts 20 against 2,000). To Lewis, oil needs long term break-evens of $10 to $20 per barrel to remain competitive in mobility. That looked very far-fetched a few months ago, but the price of oil did indeed drop to those levels during the Covid-19 lockdown. Will it stay that low? In the short-run, unlikely. The oil industry has always been very volatile, but it is also increasingly unlikely that it will stay consistently high, as happened in the late 2000s.
This trend can be seen as quite paradoxical to some as daily consumption increased from less than 30mb/d in the 1960s to 100mb/d, in 2019, which meant that the world has been extracting a growing amount of oil over the years while the price of this non-renewable natural resource did not follow an upward trend. The reason is that, in the tug of war between depletion and technological innovation, the latter is winning, and that is bad news to OPEC/oil exporting countries. Not only we are finding more oil, we are also finding more alternatives to oil.
Consequences and conclusion
Given these forces, and with reserves amounting to 100 years in some cases, a rational approach to OPEC member nations is to accelerate their rate of extraction and avoid having huge volumes of stranded reserves. That may be inevitable if they want to gain market share lost to producers in the United States, Brazil, Norway and even new comers such as Guyana. Besides, by keeping costs low, they will delay the speed of energy transition.
This is a big change of paradigm, from a position of strength for having huge oil reserves to one of weakness, reducing price to sell a stock while there is a market for that.
The realization that perhaps OPEC countries have been producing too slow, and giving away too much market share to competitors, suggest an acceleration of volume growth and accompanying fall in average prices. The consequences of a low-priced (around $30) barrel from now to 2030 are drastic. A study that this author conducted, based on a field-by-field analysis of break-even prices and government revenues, shows that a fall from $60 to $30 in oil price can lead to a reduction, on average, of capital investments by $170 billion per year. Much more affected will be the government take, as is termed the combination of taxes and royalties that governments receive from their oil production. In that, the average loss per year can reach $616 billion.
Lower government oil revenues will put pressure on the societal bargain that characterized rentier states, whereby rulers provide citizens with oil wealth through generous jobs, scholarships and subsidies, in exchange for political quiescence. Saudi Arabia’s recent move to triple value-added taxes and cut benefits may be a signal of more to come to a region which, until recently, was tax free. With fewer subsidies and reduced domestic purchasing power, it makes it more challenging to prop up the non-oil sector of the economy through ambitious structural transformation programs such as Saudi’s Vision 2030.
The economic consequences feed directly into domestic and foreign politics. Diminishing sources of patronage reduce the costs of joining opposition ranks, and where the political system does not offer room for peaceful alternation of power, violence can ensue. Furthermore, as oil becomes an increasingly less critical commodity to the world economy, superpowers may be less inclined to come to the defense of politically challenged leaders. At a minimum, their bargaining power is expected to shrink.
Some of these strategic considerations were clear before the Covid-19 pandemic. A document by IEA from January of 2020 (“The Oil and Gas Industry in Energy Transitions”) saw a possible scenario where resource holders ramped up their extraction rate capacity to force high-cost producers out of the market. The consequence would be to bring prices down to between $25 and $35.
What the Covid-19 may have done is to anticipate what analysts were already predicting to happen before the end of this decade, the peak of oil consumption. Once corporate policies and communication infrastructure (high bandwidth connection, Zoom subscriptions, cloud computing, etc) have been put in place, work-from-home practices might become widespread, representing a permanent hit to the oil industry by reducing the demand for transportation. There is also some evidence that countries may opt to stimulate more local, rather than global, value chains. Driven by rising protectionism or security concerns, fewer goods moving across borders also means another hit to the transportation industries of trucks and ships.
If, in the 1970s, OPEC needed to fear only the competition that came from oil supplied from other countries, now it is facing real substitutes, which are gaining momentum thanks to technological advances in renewable sources of energy and electric vehicles. Besides, intense societal pressure and investor activism against climate change can further accelerate a transition out of fossil fuels, an issue absent during the heydays of the oil organization. To add to that, changes in transportation patterns may accelerate the peak in consumption.
It is too early to say what the new normal will be, and, in the short-run, prices may rebound. In fact, the oil industry will continue to be a significant source of employment and government revenues for years to come, but at a decreasing rate, along with the power of the “oil weapon.” It is telling that, unlike key moments in its past 60 years, when OPEC came to the headlines by asserting sovereign control of natural resources and using oil embargoes for political leverage, its biggest production cut in history will be marked by an attempt to prevent oil prices from free falling even more. In addition, the medium- to long-term perspectives are not working out in their favor.