This past week OPEC (Oil Producing Export Countries) reached a tentative agreement to reduce output. While this is only a tentative agreement, expectations are that it will be finalized. This move resulted in a significant increase in the price of oil.
In recent years there has been little in the way of agreement among the OPEC countries. This is one of the reasons that has allowed for oil prices to have come down. Also, on the supply side the major increase in production in the U.S. has helped to keep oil prices lower.
Besides the increase in supply, demand for petroleum products has been weaker than anticipated over the last several years. This is due in large part to the global economy growing less than forecasted. Also, vehicles have become more fuel efficient, though the recent increase in the share of SUV’s has somewhat negated that trend.
Another factor in the OPEC decision to restrict output is Iran becoming once again a major oil exporter. With Iran back in the oil market this was starting to cause an even greater oversupply of oil.
In years past Saudi Arabia, which is the largest OPEC producer, has tended to be the swing producer in trying to stabilize oil markets. However, in recent years Saudi Arabia has increased its oil production in part to retain market share. With Saudi Arabia and other OPEC countries currently running budget deficits there is more of a sense of urgency for OPEC to make changes.
While OPEC is a major oil producer, it still accounts for less than 50% of worldwide oil production. Its market share has been eroding over time, as non-OPEC producers have increasingly gained market share.
This certainly does not mean that OPEC is irrelevant, as this recent action did cause a significant increase in oil prices. Nonetheless, OPEC no longer has the kind of market power it had in the 1970’s, when its actions caused a dramatic rise in oil prices.
It should also be noted that it is very difficult for cartels to remain effective over the long run. While an agreed upon reduction in production can raise prices and benefit all members of the cartel, there is an incentive for members to “cheat” on their production targets. This “cheating” will cause supply to increase again, and prices will fall, if this happens.
For consumers this recent increase in oil prices would impact the price of gasoline by about $.10 per gallon. However, from a seasonal standpoint gasoline prices normally fall this time of the year, as refiners switch to the lower cost winter blend, so the near term impact on consumers will be minor.
For a longer term perspective it is really more important what happens with non-OPEC oil supply. Most of the OPEC producers can produce oil at a relatively low cost, so they can keep producing even when oil prices are relatively low.
In our country much of our new oil discoveries have a higher cost structure, so our oil production is starting to decline with the relatively low oil price environment. Projects that made sense when oil was at $80 per barrel will not necessarily be profitable when oil is $40 to $50 per barrel.
Consumers should be aware with oil being a commodity, it is subject to major price swings. A 1% change in worldwide oil demand or supply can typically impact prices by 10%, so larger changes in supply or demand will have a much greater impact.
For now the world has an ample supply of oil, so this move by OPEC will only have a minor impact on what consumers pay at the pump. However, consumers should be aware that significant oil production comes from parts of the world that are not stable, so a major supply disruption is always possible, which could have a major on gasoline prices.
