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The cartel knows how to maintain prices and keep demand

25 Jun 2018 17:47|Marcin Lipka

“Apparent confusion and various messages are in fact part of an intricate game after Friday's meeting of the oil market tycoons. It is calculated to maintain the highest possible prices while keeping the demand for the raw material. Unfortunately, for all of us the cartel has solved the paradox. This means high prices at fuel stations," writes Marcin Lipka, Conotoxia Senior Analyst.

Marcin Lipka, główny analityk Cinkciarz.pl

Theoretically, we live in a highly competitive world. Margins on many products are low, the competition between retailers and manufacturers prevails and consumers are flooded with an incredible amount of goods to choose from.

However, the free market does not apply to oil. Almost half of its production is in the hands of 24 countries, which created a cartel for price regulation, mainly consisting of OPEC member states and Russia. OPEC+ was created after the price of oil slipped out of oil producers control in 2015-2016. It was when the US shale revolution pushed prices below $30 per barrel.

Stock and production management

The main task of the Cartel is to obtain a mining premium which is much higher than the margin that would be obtained in free competition. In this case, it is necessary to manage production and stocks in such a way that, on the one hand, the price is relatively high but not above a level which could, for example, stifle demand.

In addition, energy resources are extracted in places with unstable weather conditions (e.g. the Gulf of Mexico) or in regions where geopolitical interests are strongly intertwined (the Persian Gulf, Latin America). We should also not forget about natural disasters (e.g. fires that impaired the production in Canada a few years ago) or unusual events such as strikes (such as those in Kuwait).

For this reason, oil companies create stocks (separately from those managed by states). For consumers, the higher the stocks (of course, to a certain degree) the better. This is because in case of the disruption in production, they smooth out price changes and the problems of one or another producer not increasing prices.

For OPEC+, stocks have become the biggest problem, as their high levels make it impossible to manage supply management. When stocks are close to the producer's preferred level, then price regulation is much easier. After several months of stock declines, its optimal level has now been reached. So what is next?

Vienna Game

However, the stock levels preferred by OPEC+ have already put upward pressure on oil prices, especially in the context of sanctions against Iran and Venezuela's economic disaster, which could reduce global supply by more than a million barrels per day in the next quarters. This is too much, especially as the change in oil prices has been strong comparing to last year and in addition, President Trump has put pressure on Saudi Arabia to increase production.

On Friday in Vienna, where OPEC and Russia representatives met, it was announced that production would be increased by 600 thousand barrels per day (bpd) in real terms and 1 million nominally. Why did real growth differ from nominal growth on Friday? This is due to the rather unclear selection of the reference point, which is the consistency of the extraction level with the 2016 findings.

Many countries (e.g. Venezuela, Angola, Algeria, Mexico) reduced production more than required in the agreement from less than two years ago. This meant that the overall reduction in extraction was greater than expected. Therefore, the target has become 100% compliant with 2016 conditions.

However, on Friday it was not clear whether 100% of the compliance was with individual countries or with the cartel as a whole. According to media delegates or the official conference in Vienna, the compliance would be on a country-by-country basis, but this meant not a million bpd of additional supply, but between 600,000 and 700,000 bpd due to the fact that some countries were physically unable to increase production despite the easing of restriction. This caused the increase of oil prices on Friday, which was probably not the aim of the cartel (or at least not in the coming days).

On Saturday, when further talks took place (in the context of further cooperation within OPEC+), it was nevertheless announced that the increase in production would be up to 1 million barrels.

Targeted action

Do not assume that OPEC messages are random. The confusion was deliberate in many ways. Firstly, every country could return from the Vienna trip as a winner. The countries that could not increase production saved face because the overall increase in production was limited. The U.S. allies fulfilled the White House's pressure because production has increased.

The cartel may also have feared that a clear message of a million barrels could lower prices too much, that is why the information was ambiguous. However, Friday's price increases were too high (4-5 per cent) to be left unanswered, so the promise was clarified. But is that great news for drivers? Not necessarily.

OPEC+ works to maintain optimal prices for producers. It has not disintegrated despite many divergent geopolitical interests. The promise of increasing production will therefore be smooth and adapted to the current situation, and will of course be aimed at maintaining the highest possible price of crude oil. The cartel will solve the paradox, but we will all unfortunately pay for it.

25 Jun 2018 17:47|Marcin Lipka

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