OPEC’s biggest cut

The oil export cartel OPEC has announced the biggest ever cut in planned production in a bid to rebalance supply and demand in a market where crude oil prices have fallen by over two-thirds (> $100) within the space of a few months.

OPEC is reducing output by 2.2 million barrels per day – on top of the 2 million contraction in supply announced earlier on this autumn. The total cut in production is equivalent to lowering global oil production by around 15 per cent. OPEC – which accounts for forty per cent of world oil production – has a supply target of 24.845 million barrels per day

It was significant that Russia – the world’s biggest oil producer outside of OPEC was invited to attend the meeting. But in the immediate aftermath of the announcement they said that they will not join the attempts to restrict supply and that they do not wish to consider joining OPEC at this stage. The first reaction of international commodity markets to the OPEC supply cut was to reduce prices still further!

Demand and supply forces

OPEC’s attempts at stabilising the price through lowering output quotas will only have a marginal impact on the world price. Demand-side factors have taken over as the dominant driver of the price of crude oil in the short term and with the global economy set to suffer a recession in 2009 there is precious little that OPEC can do for the moment.

Price and marginal cost – the value of extracting oil from the ground

This short quote from the Saudi oil minister reveals some important microeconomics:

“You need every producer to produce and marginal producers cannot produce at $40 a barrel.”

Extreme price volatility in the markets for primary commodities such as oil, gas and iron ore creates headaches for producers who must commit huge and expensive resources to exploring, drilling, extracting and then refining their basic output

Marginal cost is the change in total cost resulting from supplying one extra unit to the market – in our example, the marginal cost is the expense of extracting an extra barrel of crude oil from below the ground. It is a widely held belief among economists who specialize in commodity prices that the long-run market price of something is determined fundamentally by the marginal cost of production. The resources that can be tapped at lowest cost are often done so first, and then as it becomes progressively harder to unearth such resources the market price must rise to provide an economic incentive to do so.

One immediate problem is that, because oil is a non-renewable resource lying in geological structures that vary enormously in location, weather, depth and many other variables, the cost of extracting new supplies is hard to determine. Many OPEC countries – especially Saudi Arabia – have access to relatively cheap and elastic supplies of oil. But the same cannot be said of crude oil producers in Canada’s tar sands and oil companies who have sunk huge amounts of money into exploiting the oil available in deep-water facilities off the west coast of Africa or in Brazil.

The fact is that for many oil-exporting countries, the price for each barrel of crude oil extracted needs to be higher than the marginal cost of production for national governments to generate sufficient income to pay for ambitious public spending projects.

So whereas the Saudi government can expect to balance its budget when world oil prices are hovering at around $55 per barrel, prices need to be closer to $70 a barrel for the Russian government to earn enough oil revenues to pay for their state spending. And that figure rises to more than $95 a barrel for countries such as Iran and Venezuela.

If prices fall below the marginal cost of production will we see a sharp contraction in supply? Economic theory would suggest yes for, if crude oil prices slump to below $60 or $50 a barrel, petroleum companies with above-average production costs may decide that the price has fallen below the short run shut-down point and opt instead to mothball oil wells, because pumping oil out of the ground has become a licence to lose money.

Indeed the fall in production may be much larger than this – because exploration and development is an expensive business. Oil companies need to know that the price they can command in the market will be persistently above the marginal extraction cost in order to cover the fixed costs of production and the expected rate of profit demanded by shareholders.

It looks like OPEC is targeting a price of $75 a barrel as a ‘fair price’ for oil producers. Given the weakness of the world economy, that might take some time to happen.

Suggestions for further reading:

The Times: OPEC makes largest ever cut to oil production

BBC: OPEC agrees record oil output cut