That “no increase in oil production” accord between Saudi Arabia and Russia last week was so laughable. They can’t even get an agreement from Iran to stop increasing production. Forget about trying to get people to cut production. Perhaps what they need is an outsider’s perspective…
One of the more memorable examples from business school was the following:
If there are 96 pants that must be sold and 94 customers needing just one, prices are going towards zero. Prices are going to keep getting pushed down as no one wants to have one of the 2 pants that don’t get sold. If you burn 4 pants, prices are going to skyrocket, as no one wants to be one of the 2 that go pants-less. It may not occur to most people that you can sometimes make drastically more money by taking inventory off-line. The oil market is similar to this example because the supply and demand curves are very steep in the short term. Just a small nudge could send prices skyrocketing (in either direction).
One way to take inventory off-line is the old OPEC system, with group production cuts. That worked okay when your members had a 50+% share of the oil market and cheating (countries not fulfilling their pledges) was somewhat limited. But most of the oil countries are running massive deficits so the urge to cheat is great. And group cuts don’t work so well when OPEC only has a 40% share. When you are a smaller group, you have less of an effect and everyone else will benefit disproportionately. Trying to deal with cheating and free-riders in the old framework is almost impossible in this environment.
Here is my idea that addresses the above. Note that I know almost nothing about the oil market:
- You only need ONE country to cut production. Total world oil production in 2015 was 95.6 million barrels per day (“mbd”), but consumption was only 1.8 mbd lower, at 93.8. As with the pants analogy, we probably only need a reduction in supply of about 4 mbd to get a huge effect. Trying to get every oil producing country to agree to a 4% production cut (or just OPEC to agree to a 10% production cut) and not expecting there to be rampant cheating is just a fantasy. This is where real leadership comes in. What if Saudi Arabia just came out and said they would reduce their own production by 35%? It’s much easier to monitor one country than multiple countries. Since Saudi Arabia produces 11.9mbd, this would be a 4.2% reduction in world production, and oil consumption will then be noticeably greater than supply. What would happen to oil then? I think oil would be at least $60 (double the current levels) with upside risk, according to my WAG model.
- Why would Saudi Arabia (“SA”) do this?
- They get paid – using a crowd funding model. It would go something like this… you get a pledge from 65% of the world’s oil production to pay you 15% of all oil revenues above $40 per barrel (currently $30). All the underlined numbers could be tweaked. If you are Russia, wouldn’t you like the idea of a FREE bump in oil prices by $10 to $40? The only cost would be a lousy fifteen cents for every $1 that oil prices are above $40. If oil gets back to $80, are you really going to complain that you had to pay SA $6? Really?!? You basically have to be some kind of knucklehead to not jump on this in the current environment (i.e. no relief in sight). With the old OPEC system, you have to give up something (production), to possibly get something (higher prices). With this system, you have NO risk as a producer! You produce as much as you want. If you sign up and oil sits here, you lose nothing! Even if you are the biggest selfish leech on the planet, if you see the pledges are only at 60%, are you going to risk the deal not going through? If you don’t pledge, and this deal does not get done, you get NOTHING. So why wouldn’t you pledge? The problem with the old OPEC model was that there was limited participation. This new system is more inclusive – not just to oil-producing countries, but to private producers (Exxon, Shell) and anyone who wants higher oil (investors, speculators, hedgers). Setting the minimum total pledge will reduce some (not all) of the free rider problem, since it this has clear benefits for producers and they would want to nudge things along in that direction. Some participants may like the idea more than others, and those folks could contribute more. If Exxon thinks that’s worth 20%, they can pledge more than what their production implies. Saudi Arabia’s break-even using $40 and 15% would be less than $43 – below this SA loses money (as compared to current production and current $30 oil), and above this is all gravy. If we get to $80, SA makes 2.8x what they are currently making, and 4% more than what they would have made had oil just went up to $80 by itself (which it wouldn’t in this environment). SA is taking a risk, but is it really a “risk” to say if they cut 35%, oil would spike by $13? As previously mentioned, I think oil would double.
- Cement their role as the most important oil producer. A country with only 12.7% of the world market will dominate the oil universe. Never underestimate ego.
- They use the time off to do other things. Oil is going to run out in two generations (more or less). You will have some free resources on the 35% that will not be involved in the curtailed oil production. You can retrain your work force, develop infrastructure, engage in public works projects, or start Peace Corp-like projects in the region to build Arab goodwill. These are the type of things that leadership countries do in an ideal world.
- Save your resources for later. If you could choose, do you want to unload your bounded oil supply now at these prices, or later? Later… like when shale production declines in a few years (as per projections), or much later… like when people start getting paranoid that oil will run out. Battery technology is currently crap. Anyone owning an Apple watch or any battery-powered device ever created will attest to its weak performance over time. The world will still need oil for a long time. Even with the global environmental accord, oil consumption is projected to increase steadily for decades (according to the IEA).
- It doesn’t even have to be (just) Saudi Arabia. Saudi Arabia could partner with some countries if they wished. Saudi Arabia doesn’t even have to be involved. You only need one (or a few) large producers to put this on the table.
You don’t even need this to ever be implemented for this to “work.” A close projected result would completely annihilate all the oil shorts and that alone could get oil above $40 temporarily. This should give additional incentive for people to pledge. I suppose if you stall for a year or two, you might even get to a more favorable production/consumption mix where this is not needed.
What if higher prices lead to more oil exploration/development? This is possible. But fruit is picked from the bottom of a tree. I assume other sources of oil will be more costly than the current mix. If having much higher oil prices is a pre-condition to some other problems possibly arising, is it really a problem? And new production will probably only balance out the shale that has been getting used up.
The current supply glut/storage could be an issue. But this will get wound down. A deficit of 2 mbd equates to a draw of 700 million barrels a year. You can always have this be a longer-term agreement. Or you can cut more sharply.
I’m not saying there aren’t numbers that need to be changed or details that need to be worked out. There are legal, methodology (blind vs visible), measurement, payment, timing and various other issues that need to be resolved. I’m just proposing this as a framework that could be pursued, because this makes a lot more sense from a game theory perspective than to try and get a small group of people to agree on cuts.
I feel like an old Saturday Night Live skit… I am Keyrock – the unfrozen caveman (Curve) Advisor. The world of oil frightens and confuses me. I don’t know anything about oil, other than my pet sabre tooth got swallowed up by a petroleum tar pit. But I do know this… it doesn’t take a lot for oil production to be reduced if the producers can be made to have similar goals… You can always count on greed.
Yes – I realize I shouldn’t be helping the producers manipulate prices. But we just seem to be at a strange point where the markets get really depressed/concerned about low oil prices. I have no idea why we aren’t celebrating it. In any event, I’ll consider this my gift to the Arab world in this time of turmoil and my west Texas neighbors.
 US Energy Information Administration. https://www.eia.gov/forecasts/steo/report/global_oil.cfm
 Wild-Assed Guessing
 I prefer a two-tiered system, where at say 80% it is guaranteed that SA will go through with it, and at 65% it will be under consideration. But I’m going to keep this simple.