Why OPEC is Prolonging Cheap Oil (And Why It May Backfire This Time)

In the face of falling oil prices, OPEC found itself under the market's microscope.  News that the cartel was holding production steady at 30 million barrels per day and revising production for 2015 lower to 28.9 million barrels did little to placate volatility-averse traders, who in turn sent US treasury bonds further south, the Dow Jones (DJIA) plunging nearly 300 points and generally had a negative impact on everything from the Canadian Dollar  (CAD) to the Norwegian Krone (KR).  By almost any metric, the markets were affixed on commodities, and specifically fossil fuels.

Seemingly serving as a reminder of just how beholden we are to the black gold, oil played a role in numerous geopolitical developments this past year.  From the thawing of relations between Cuba and the United States to the NATO and EU sanction regime meant to punish the Russian economy, 2014 saw fossil fuels once again take on the role of political flashpoint, furthering some agendas while hindering others.  But the reasoning behind why the Arab-dominated OPEC is dragging its less fortunate members through the mud has all to do with recapturing a near monopoly on oil production it enjoyed on oil exports before high prices drove investment towards U.S shale.

 OPEC was initially formed in 1960 by countries with substantial oil reserves in order to collectively better control the market for exports.  What they discovered during the Yom Kippur War in 1973 was that putting a vital resource under the control of a non-aligned cartel provided OPEC's Arab and Latin American member states with an "oil weapon" that provided them leverage with otherwise superior western powers.  In a move meant to punish the United States and its western European allies for supporting Israel in that conflict, OPEC agreed to an oil embargo.  The subsequent spike in oil prices and ensuing chaos led to a significant change in U.S energy policy, as the hardships experienced by both industry and consumers led to renewed efforts to conserve oil, increase fuel efficiency and develop alternatives to oil.  If OPEC's oil weapon was able to cause the United States and its allies significant economic hardship, why have they been loathe to use it since?

Former Saudi Oil Minister Sheik Ahmed Zaki Yamani perhaps stated his country's oil policy most eloquently 40 years ago when he said "''The Stone Age didn't end for lack of stone."  His prediction was eerily precinct, because the following decade saw various factors conspire to create a situation which at a glance may seem similar to the period of "cheap oil" in which we find ourselves right now.  A plunge in the demand for oil (to the tune of five million barrels per day) coupled with a rise in production in non-OPEC states created enough of a surplus that prices continued to fall, capping a 46% decline in 1986.  OPEC countries, historically known for exceeding quotas and inflating estimated reserves, responded to the successful campaigns aimed at reducing global dependency on oil by cutting production several times, by nearly half.  This did little to staunch the bleeding as non-OPEC states stepped in to pick up the slack, and as a result OPEC's market share fell from a peak of roughly 50% in the 1970s to around 30% by 1985.  While Saudi Arabia initially led the charge by throttling production, it found its less economically secure partners largely unwilling to engage in a price war at the expense of much needed revenue.  Fed up with essentially subsidizing excess production in other OPEC countries, Saudi Arabia pioneered the same strategy which it is applying here today, albeit with different targets in mind.

  Back then, Saudi Arabia's primary goal was to make it too expensive for OPEC's more undisciplined members to continue overproducing by dumping the price of oil long enough to run other producers out of business until it once again held major sway on the price of oil.  This time the ultimate goal is the same, but the Saudis are taking aim at the American shale producers whose torrid levels of production have been a large reason (along with the still-precarious economic position of Japan, China and the Eurozone) why prices have taken a nosedive over the past year (even with ongoing instability in Libya and Iraq.  And yet while Saudi Arabia was successful in reigning in its OPEC partners, it was helped at least in part by the fact that the Bush (Sr.) administration made a decision to to double down on Gulf-supplied oil, ramping up military aid to allies on the peninsula and scrapping policies which had been quite effective in reducing demand for oil.  If the United States actually declining to seriously invest in efforts to increase energy efficiency seems ludicrous, take a comparative look at Japan's efforts in the same area.  At the height of the oil embargo, Japan's energy security was even more compromised than that of the United States.  Consisting of a series of generally resource poor islands,  it both did and continues to import 92% of its oil.  At the time of the embargo, roughly 71% of the country's imports were derived from the middle east.  As such, when crisis struck Arab states labelled Japan an "unfriendly country" for its refusal to get involved in the Palestinian-Israeli conflict and slapped it with a 5% production cut.  Very vulnerable to disruptions in oil supply, it was forced to reorient its energy policy with an eye towards minimizing susceptibility of the economy to oil shocks.  As a result, Japanese energy efficiency today is such that it uses less than half the energy that the United States does to produce a dollar of GNP.

American strategic interest in the Middle East is waning

Those days of a Stockholm Syndrome-esque relationship between the Saudis and Americans with regards to energy policy are over.  From the toppling of Iran's Shah in 1979 up until the 2003 invasion of Iraq, the United States was heavily invested in the region and as such was willing to incur instability-induced spikes in the price of oil.  Following a prolonged economic recession which served as the culmination of a decades long decline in the prosperity of the American middle class as well as the election of a President who ran on a platform predicated upon extricating America from the Middle East, both the government and public no longer have the stomach nor faith in the ability of America to sort out a region so fiercely sectarian, conflict ridden and seemingly resentful of American assistance.  If President Bush's eight years in office were about Middle Eastern foreign policy, the electorate has demanded that President Obama's be about the economy.  To that end, his most highly touted legislative achievements have almost entirely served a domestic agenda, through major overhauls of healthcare policy (ACA), financial regulation (Dodd-Frank) and the Justice Department's tackling of social issues such as marriage equality and police violence.  If anything, this administration's most prominent foreign policy move was arguably its much discussed "Asia shift", which essentially served as a way for the President to fulfil his election promise to end the two wars started by his predecessor while at the same time not giving ammunition to critics who accused the Obama administration of retreating from a leadership role the United States had held since WWII.  Even when the United States has found itself inevitably dragged into one Middle Eastern conflict or another, it has been loathe to get directly involved, instead extolling the necessity of coalition building and Middle Eastern countries taking on a larger role in conflicts that involve them.

Saudi Arabia very well may stamp out frackers, and once again gain some degree of control over oil prices.  Fracking is expensive, with a break even price of around $50 per day.  Already western producers are laying off workers and slashing exploration budgets, as petrodollar economies adjust for a rough landing.  But Saudi Prince Alwaleed bin Talal agreed that the days of high oil prices are essentially over.  Electric cars are on the verge of going mainstream, and just about every country has launched ambitious plans to cut carbon emissions and increase the share of renewables in energy consumption.  Oil will continue to be an important commodity for years to come, but the point has come where countries such as Venezula, Russia, Libya and Iraq who failed to diversify their economies while prices were high can no longer hope to nearly entirely fund their governments from royalty proceeds.  The world has finally become serious about pushing alternatives to fossil fuels in a bid to cut carbon emissions, and  falling oil prices might finally topple the last big obstacle to achieving that goal.  One can only hope so, at least.