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12 MIN READ - From the Cautious Optimism Correspondent For Economic Affairs and other Egghead Stuff
Throughout late 2017 and early 2018 OPEC has enacted enormous
production cuts in a Saudi-led bid to raise oil prices from the 2016-nadir of
$26 per barrel. The production cuts are a reversal of OPEC’s multi-year price
war where the cartel pumped at near-full capacity despite plunging oil prices.
But the reversal towards production cuts marks an
abandonment of their previous strategy to put the newly conceived U.S. shale
oil industry out of business and return the global market to OPEC dominance.
Since U.S. shale is producing at record levels today even as OPEC tries to
raise prices, the strategy has clearly failed and OPEC has effectively cried
uncle. Why did OPEC think they could knock out their new competitor and why
didn’t the plot succeed?
LEADING UP TO THE PRICE WAR
Early this decade U.S. shale oil producers were for the
first time able to pump oil profitably at market prices that hovered between
$80 and $100 per barrel. Spurred on by new hydraulic fracturing technologies and
production techniques, oil and natural gas production boomed in areas like the
North Dakota Bakken and South Texas Eagle Ford formations. After decades of
steady declines, American oil production began to rise rapidly early in the
2011-2014 period.
OPEC, whose cartel of nationalized oil companies has enjoyed
control of a large share of world oil production capacity, saw U.S. shale oil
production as a new threat to not only their dominance, but the ability to
partially control world prices through coordinated production increases and
cuts among its members. True, some OPEC members “cheated” from time to time and
continued to secretly pump oil despite agreements not to, and the result was
OPEC was often not able to place world oil prices exactly where it wanted, but
the appearance of a new and very large non-OPEC producing nation would greatly
undermine OPEC’s long-standing leverage. Cartel leaders, particularly Saudi
Arabia, correctly identified U.S. shale as a threat and plotted to eliminate it
through a price war.
As shale oil poured out of the USA, the ballooning supplies
pushed oil prices below the long-standing $80 floor in late 2014. Once oil
prices fell below shale breakeven points, U.S. shale producers predictably cut
back on now unprofitable projects. But OPEC continued to pump at full capacity
since, after all, its conventional oil production costs were lower. However the
real objective this time was to drive prices so low that the entire U.S. shale
industry was bankrupted and wiped off the map.
A little-reported complication for OPEC is that despite
lower production costs on conventional Middle Eastern oil, OPEC member governments
are heavily reliant on revenues from their national oil companies to finance
their fiscal budgets and operations. Saudi Arabia for example is estimated to
have a breakeven production price of only $12, but it spends more than $50 of each
barrel’s revenue to fund government programs (the exact numbers are a secret
but experts believe these estimates are close). So as OPEC’s refusal to cut
production drove oil prices down further and further, many member countries
actually began to lose money as their government expenditures outstripped
per-barrel revenues.
Over the 2005-2014 decade as oil prices usually hovered well
over $80 Saudi Arabia and other OPEC members were able to produce profitably,
fund their government operations, and still enjoy profits that were diverted
into burgeoning reserve funds. But in 2015-2017, even as oil prices fell to
$50, then $40, and even $30 they planned to tap into those reserves and wait
out the price war until competition from U.S. shale was bankrupt—driven out of
business by losses. Then, according to the plan, OPEC would recapture its
traditionally dominant market share, cut production, raise prices back to
$80-$100 or higher, and enjoy enormous profits that replenished their diminished
reserve funds.
This is the classic strategy of so-called “predatory
pricing” which dominates mainstream economic thinking in the monopoly and
antitrust field. Drive prices down to the point of losses, outlast your
competition with your war chest of reserves that allows you to better withstand
those losses, and then when no competitors remain establish a monopoly that
allows you to jack up prices, replenish your war chest, and go on to enjoy bonanza profits that gouge the consumer forever.
Yet the strategy failed and after three years Saudi Arabia
and OPEC threw in the towel. Why?
THE PREDATORY PRICING FALLACY
The theory of predatory pricing has been with us since the
late 19th century when Ida Tarbell wrote her fallacious muckraking newspaper
series accusing John D Rockefeller’s Standard Oil of the practice. In the
century-plus since the idea has been propagated among academics and the media,
and it easily caught on with a (mostly uninformed) general public since it
appeals to a victimization mentality that proposes consumers are helpless in
the face of a market leading firm with enough power to drive all competition
out of business through lowering prices and then enjoy an abusive 100%
monopoly market share.
Such was the idea OPEC had of regaining their dominant
market share, encouraged undoubtedly by their own economic advisers who they’ve
sent to study at American Ivy League universities to study mainstream economics
for decades.
However in practice no one has ever been able to produce an
example of a firm that successfully achieved and then held a monopoly market
share with this strategy. A few firms that achieved close to 100% market share
such as Standard Oil and ALCOA did so not through predatory pricing, but rather
through relentless innovation and cost-cutting that continuously benefited consumers.
Companies like Standard Oil and Alcoa consistently grew their market shares
profitably, never by incurring years of losses to destroy competitors followed
by giant price hikes. OPEC’s failed attempt to drive out its competition is
another example that fails to prove the theory.
Furthermore any examples of coercive monopolies that have
abused consumers with impunity have all been monopolies established and
protected by government legislation—not free market practices. AT&T
famously gouged consumers on long-distance telephone rates from the end of
World War I to its breakup in the early 1980’s, but what’s less well known is
that AT&T was formed by an act of Congress that forced all of Bell
Telephone’s competitors to merge into a single entity (at the urging of Bell
incidentally, which was losing market share to new competitors) and then
granted the new national telephone company a monopoly on all long-distance
service. Most cable television operators are granted local monopoly licenses by
municipalities in exchange for broadcasting certain content “in the public
interest.”
In fact, not only is empirical evidence lacking that
predatory pricing has ever worked, the theory itself is full of holes.
University of Chicago’s John S. McGee famously wrote in his late 1950’s paper
on Standard Oil that predatory pricing was a flawed theory and irrational
strategy for several reasons. Loyola University economics professor Thomas DiLorenzo
sums them up as follows:
1. “As an investment strategy, predatory pricing is all cost
and risk and no potential reward. The would-be 'predator' stands to
lose the most from pricing below its average cost, since, presumably, it
already does the most business. If the company is the market leader with the
highest sales and is losing money on each sale, then that company will be the
biggest loser in the industry.”
2. “There is also great uncertainty about how long such a
tactic could take: ten years? twenty years? No business would intentionally
lose money on every sale for years on end with the pie-in-the-sky hope of
someday becoming a monopoly.”
3. Even if a firm was able to withstand years of losses and
finally establish a monopoly, “nothing would stop new competitors from all over
the world from entering the industry and driving the price back down, thereby
eliminating any benefits of the predatory pricing strategy.”
Thomas Sowell adds yet another contradiction in the theory,
one that is particularly relevant to the OPEC story:
4. “Even the demise of a competitor does not leave the
survivor home free. Bankruptcy does not by itself destroy the fallen
competitor's physical plant or the people whose skills made it a viable
business. Both may be available-perhaps at distress prices-to others who can
spring up to take the defunct firm's place.”
In the case of U.S. shale, OPEC wasn’t even a market firm
but rather a cartel of coercive government-sponsored national oil company
monopolies. And yet even with all its governmental powers OPEC could only
succeed in bankrupting some operators, but hardly all.
And even some of the bankrupt producers reorganized and
resumed operations with a cleaner balance sheet. Those that ceased operations
altogether simply capped their wells and sold the assets off at firesale prices
to other firms. The buyers, who obtained the already drilled wells at very low
cost, could now operate without the burden of heavy debts that plagued the
original producer.
So now if OPEC were to cut production and raise oil prices
back to $80-$100, they would face the same competing wells again but run by
producers who enjoy lower costs due to lightened debt loads and smaller
interest payments.
So according to theory skeptics, in the end the market share
picture would not change all that much only that Saudi Arabia and other OPEC
members would have burned through decades of reserve funds that were lost in
the trade war.
ENDGAME
As the price war dragged on through 2015, 2016, and most of
2017, the Kabuki theater performance played out exactly as predatory pricing
skeptics would have predicted—with two additional twists, both of which worked
against the Saudis (more on that in a moment). OPEC continued pumping and oil bottomed out at a shocking
low of $26.
Several smaller, higher cost shale players did go bankrupt. Some
reorganized and stayed in business. Others sold off assets in bankruptcy
auctions (assets that continued to operate under new production companies) and
some ceased operations and capped wells—assets that lie dormant and wait for
oil prices to rise again before producing.
But most shale players and virtually all of the major U.S.
oil and natural gas players weathered the storm and survived, even as profits
fell sharply or they incurred losses.
Meanwhile OPEC member states burned through their reserves
at an alarming rate. By some estimates Saudi Arabia’s reserves were down over
40% in just 2-1/2 years and were still falling rapidly in early 2017.
Reserve funds that had taken decades to build up were being
decimated in just a few short years. In a recent 60 Minutes interview with
Crown Prince Mohammed bin Salman, one of Saudi Arabia’s top economic advisers
confessed to CBS that the kingdom was heading toward a major sovereign
financial crisis in a few years if it did not change course.
Hence in late 2017, seeing most U.S. shale and conventional
energy E&P players still in business and watching their own reserves
dwindle, the Saudis threw in the towel and called for the first of what would
become a series of production cuts to raise prices.
Now in early 2018 oil
prices are off their $26 lows hovering near $70, but U.S. shale is still here
and producing more than ever. If OPEC’s goals were to incur losses in exchange
for eliminating the U.S. shale oil industry, they succeeded only in the first
and failed miserably in the second.
In the end the OPEC predatory pricing scheme has been a
giant flop that has cost them hundreds of billions of dollars.
To add insult to injury, two unexpected twists added to
OPEC’s failures.
First, during the 2014-2017 price war, shale oil technologies
continued to make revolutionary progress and production costs plummeted even
further. Even if breakeven prices for shale had remained $60 or $70, OPEC’s
plot would have flopped anyway, but lower production costs only accelerated its
demise. New and improved 3-D geological surveying, horizontal drilling, drill
bit, fracturing fluid and computerized drilling technologies reduced well
completion times, increased oil and natural gas well recovery rates, and cut
production costs nearly in half again.
The decline varied from shale formation
to formation, but as you can see here typical breakeven costs have fallen by
around half in most areas. For example falling from about $68 to $30 in the
North Dakota Bakken, $82 to $40 in the Eagle Ford, and $81 to $32 in the
Permian Delaware formation.
And this data is already old—from 2016. Production costs in
early 2018 have surely fallen further. U.S. shale turned out to be a lot more
resilient than OPEC had hoped.
The other twist is that oil and natural gas production has
opened or expanded in several new formations across the country since the price
war began. In 2014 production came predominantly from the North Dakota Bakken
and South Texas Eagle Ford. But in the years since oil and natural gas have
poured out from the Utica and Marcellus formations in the north Appalachians,
the Niobrara of Colorado and Wyoming, and the North Texas Barnett to name just
a few.
But most of all, a herculean production boom has restarted in the West
Texas Permian.
The Permian was a major conventional oilfield in early 20th
century—part of the historical Texas boom seen in old Hollywood films. However
starting in the 1970’s production of conventional oil dwindled as easy-to-reach
oil was exhausted and the Permian was mostly abandoned—thought no longer
profitably recoverable.
However underneath the conventional fields were vast
additional supplies of oil and natural gas trapped in shale formations, and the
shale fracturing revolution has reopened the Permian for business. Recovery of
its tens of billions of barrels of shale oil and nearly 100 trillion cubic feet
of shale natural gas has ramped up quickly, and in early 2018 the Permian alone
already accounted for approximately one-quarter of all U.S. oil production;
approximately 2.5 million barrels a day.
As OPEC continues to cut production and oil prices creep up
slowly, the cartel’s leaders have been forced to watch helplessly as U.S. shale
producers move in to fill most of the gap. In the past OPEC’s cuts may have
produced prices topping well over $100 by now. Instead they are in the high
$60’s. Their only hope now is that worldwide oil demand will grow rapidly
enough that even U.S. shale will not be enough to prevent triple-digit oil
prices. But even if that day eventually comes, the USA will also share in the
spoils with its own domestic windfall profits and high-paying American jobs.
The U.S. is already forecast to be the world’s largest oil producer in 2018 and
a net energy exporter by 2023. Its burgeoning energy exports will also make a
sizable dent in the highly-publicized trade deficit, and a lot less money will
go to parts of the world that many argue “hate us.”
And of course OPEC’s dream of destroying U.S. shale and
capturing its old dominant market share is a distant memory. The grand plot
failed and the cartel’s members burned through a fortune of losses—losses that
were effectively wealth transfers to the world’s energy consumers in the form
of a windfall plus, unfortunately, national and state governments that viewed
lower prices as an opportunity to stealthily impose energy tax increases. OPEC
has learned the hard way that mainstream antitrust and monopoly economic theory
usually doesn’t work.
Perhaps they shouldn’t have sent those advisers to Ivy
League schools and considered alternative free-market-friendly universities
instead. Studying at University of Chicago, George Mason, or San Jose State
instead of Harvard, Yale, and Princeton would have saved them tens of thousands of dollars in tuition costs—and a few hundred billion in oil losses.
