There has been much discussion over the last few days on the meeting OPEC plans to hold in Algeria on 28th September. Will the more oil-price-fragile OPEC members achieve their goal and manage to align the rest of the party to reach an agreement to freeze production?
The prevailing opinion is that it will not happen. No matter how desperate Venezuela, Nigeria or Ecuador are, it is unlikely that Iran will agree to a freeze in production, which is thought to be the main obstacle for Saudi Arabia to give in.
Hundreds of articles have been written on the matter since last Friday, when rumors about the possible agreement started, speculating on whether the agreement could become a fact. Everybody is expectantly following this affair because it could change the course of oil price. But here’s the thing: OPEC cannot freeze production.
Since 1973 OPEC has successfully been able to dictate prices by adjusting production, thus today an adjustment—a freeze in production—holds the potential to increase oil price, right? Well…no. Only with the invaluable collaboration of its greatest ally has OPEC successfully been dictating prices until recently. However, this inestimable ally, price inelasticity of the oil supply curve, is not there anymore to help.
This simply means that OPEC cannot freeze production. Why not? They just have to close a few valves and supply will be reduced, forcing the price to increase, right? Well…no again. Indeed, in the short term this would drive prices up, but it will not be able to achieve any long-term or unrestricted change in price behavior.
This is so because of another force that has just made a debut, but this time on the free market’s side. This new ally, price elasticity of the oil supply curve, is OPEC’s greatest threat and is capable of providing elasticity in the supply of oil at least for a few hundred thousand bopd and up to one- or two-million bopd. The massive shale oil plays that have been developed lately are responsible.
Traditionally, an oil project would take some five to ten years from the moment oil is discovered until a field has been developed and first oil is achieved, so that a raise in oil price would only put majors to work, hoping that in five or ten years, when the oil they are discovering now comes into production, prices will still be high.
With the new, massive shale plays and the entire infrastructure that has been developed around them, an increase in oil output from these players would almost immediately follow an increase in oil price, which would, in turn, increase supply and drive prices down again. Get it?
It is a catch 22 situation in which, if OPEC cuts production, price would momentarily increase but then it would rapidly drop again due to the effect of an increase in supply from the new players, which can now act swiftly on price variations. OPEC would have not been able to effectively raise prices and it would have done so at the cost of a lower market share.
This paradigm shift will have a tremendous impact on oil price policy for the coming years. It will mean that oil price will be dictated by laws closer to those of a free market and that OPEC will have much less of a saying in oil prices, therefore, whether OPEC will reach an agreement to freeze or not, production is not as relevant as it was in the past. OPEC cannot freeze production.