The Great Switch

In a switch more diabolical than any envisioned by George Constanza of Seinfeld, OPEC may have finally succeeded in pushing non-OPEC producers back into their rightful role as marginal producers. If successful, this would allow OPEC to produce at steady rates, earn fairly high prices, and force high cost non-OPEC producers to bear the brunt of any future dips in prices.

Switching positions would be historic. OPEC has been the marginal producer since 1973. Before 1973, oil prices were low and the world had a surplus of oil wells. These extra wells gave multinational oil companies the leverage to reduce prices earned by OPEC producers. Either accept a lower price or the companies would increase oil production elsewhere.

All of that changed in 1973. By then, there were no idle oil wells outside of OPEC. This gave OPEC nations leverage over prices. Production cuts by OPEC nations could not be offset by increasing production in non-OPEC nations. Such cuts caused prices to rise in 1973-1974 and again in 1979-1981.

But higher prices gave non-OPEC producers an opportunity to produce oil from more expensive sources, such as the North Sea and Mexico. Although somewhat more expensive to produce, these oil fields put money in producers pockets and put downward pressure on prices.   To avoid lower prices, OPEC producers cut back on production.  As such, OPEC became the marginal producer.

But this arrangement was backward; low-cost producers like OPEC should have been the infra-marginal suppliers. High cost producers like Norway and the US should have been the marginal suppliers. And this role-reversal worked to the advantage of non-OPEC producers. They earned large profits on OPEC’s back, who cut production (and revenues) to kept oil prices high.

But OPEC will not cut production to keep oil prices high. Although OPEC abandoned this strategy previously, this time the free ride for non-OPEC producers is over. Non-OPEC producers have depleted their conventional sources of crude oil. The current boom in production comes from non-conventional sources, which are much more expensive to produce than conventional sources. Now price declines inflict severe pain on non-OPEC producers. Many of these producers do not make money at $50 per barrel. At that price, OPEC producers still make a handsome profit on oil that costs less than $10 per barrel to produce.

Beyond a reduction in their bottom line, the drop in prices discourages future gains in production by high cost non-OPEC producers. The very high costs of non-conventional crude oil means that fluctuations in oil prices can undermine large capital investments. This risk reduces the willingness to create new non-OPEC capacity. Combined with the price drop, this means that OPEC’s switch is likely be a success. Non-OPEC nations will be the marginal supplier for the foreseeable future.