/ Oil Politics

The Plunging Price of Oil and the End of OPEC

Along the roadsides and off the highways of America, a quiet revolution is brewing. With over 60% of gas stations across the country offering prices lower than $3.00/gallon, Americans are paying less for gas now than they have in the past 4 years.

The drop in prices would seem to come from nowhere; crude oil prices on the world market had been trending upward through normal seasonal tribulations since 2012. But since June of this year, West Texas Intermediate (WTI), a benchmark for world oil prices, has sunk over 25% from it’s high of $105.93 to under $80 per barrel, dipping as low as $75 in some brief intervals.

A free-fall of this magnitude hadn’t been seen since 2008, when the global economic downturn sent oil speculators scrambling to recover losses by dumping amassed oil reserves for cheap. However, unlike the spike and subsequent crash of WTI prices triggered by the recession, the current shift in prices is poised to have much farther-reaching and longer lasting effects.

If projections hold true, the tumble in prices since June may represent a paradigm shift in energy similar to the “oil glut” of the early 1980s. The “glut,” or a surplus of oil production from OPEC-defying producers matched with decreased worldwide consumption, standardized the cheap crude prices enjoyed by American consumers for nearly 20 years until 2003. Today, comparable conditions have set the stage for yet another energy shakeup.

Until recently, it was widely assumed oil production in the US had reached its peak in the 1970s. In 1972, 9.6 million barrels of oil were pumped out of the ground on a daily basis. Ever since that year, with the exception of a short plateau in the 1980s due to Alaskan oil investments, production steadily decreased. By 2008, domestic production had fallen to nearly half 1972 levels— a quota that hadn’t been seen since 1949.

Defying “peak oil” theorists, the seemingly unstoppable downward trend was broken by the following spring. Between 2008 and 2013, US production increased over 50% to an impressive 7.5 million barrels per day. With continually accelerating numbers already recorded in the first few quarters of 2014, the reversal seems nowhere near slowing down.

Though it’s true resumed off-shore drilling and increased investment in traditional drilling practices have certainly contributed to the surge in production, one factor stands above all as the driving force behind the turnaround: fracking. Fracking is a process that involves injecting pressurized chemical water into shale rock formations in order to create passageways for lightweight gas to escape and be captured. Originally thought to be only practical for producing natural gas, recent advances have allowed the capture of much heavier crude oil molecules known as “tight oil.”

Since 2007, tight oil (LTO) production domestically has risen from nearly nonexistent to almost 2 million barrels per day in 2013— a number expected by the International Energy Agency to double by 2018. In 2012 alone, LTO production increased by a record-breaking 1 million barrels per day. With total American consumption on the downtrend from the current 18 million barrels at an ever-increasing rate, some projections predict the elimination of oil imports to the US within 20 years. Others say even sooner.

This unprecedented surge in production did more than simply increase the world crude supply and contribute to depressed prices; it gave the US a considerable amount more freedom in relations with oil producing countries. Under the Carter administration, tight restrictions were placed on crude exports from the US to ensure the stability of strategic reserves in the face of the OPEC embargo. The policy affected little in reality when it was put into place; a decreasing US supply seemed to always keep the crude drilled domestically in the country. However, the rapid increase in LTO production since 2007 has outpaced domestic refinery capacity, leading to a new internal crude oil glut. Spurred on by tense relations with oil exporting countries— namely Russia and Iran— the Obama administration quietly reversed the 45-year-old restrictions.

On July 30, the tanker BW Zambesi left port for South Korea from Galveston, Texas with nearly 400,000 barrels of lightweight crude oil onboard— the first unrestricted oil export shipment since the Carter administration policy was put into place. Already, oil exports have nearly quadrupled from 67,000 barrels per day in 2012 to over 240,000 today. Refined oil products, such as gasoline and petrochemicals, have too seen a 33% increase in exports since 2010 to over 3.4 million barrels per day. Russia and Iran, in effect, have lost some of the bargaining power once held over European and Asian markets. Energy prices worldwide have been driven down by increased supply from America. Even OPEC has been forced to compete to retain market share.

This last point has had particular effect on market prices of West Texas Intermediate. Saudi Arabia, the largest player in the Organization of Oil Exporting Countries (OPEC), has adopted a strategy much different from the one they followed during the first oil glut. When prices began to drop in the early 80s, Saudi Arabia cut back production in an effort to keep prices artificially high. However, instead of halting the fall in prices, the policy simply reduced Saudi Arabia’s share in overseas markets, a loss that took decades to win back.

This time around, the Saudis are determined to not repeat the same mistakes. Instead of reducing output, Saudi oil minister Ali al-Naimi has taken the position to ride out what he sees as a temporary dip in prices. This is not without good reason; the Saudis cannot afford to lose their position in the market again.

Ever since the Arab Spring of 2011, Middle Eastern countries have been forced to increase social spending and welfare programs in order to appease populations and prevent unrest. Though kingdoms like Saudi Arabia can afford to operate in the red for some time, it remains unclear how states that rely on oil profits will balance their budgets. The International Monetary Fund estimates the Saudis need market prices above $93 per barrel to break even on governmental spending. Of course, as oil prices projected to stabilize at or around $70 per barrel, the energy giant’s future now seems in question.

With North American production soaring and OPEC production projected to remain at the current cap of 30 million barrels per day for the foreseeable future, the global supply of crude is on the unequivocal uptrend. In the past, increased production had always been met with increased consumption. Though this remains the case, the 1.17% increase in demand worldwide in 2014 falls well below the historical average of over 3%. When increases in supply outpace increases in demand, a price drop is inevitable.

Slow growth in consumption over the past few years can be mostly attributed to the worldwide economic crisis in 2008 and subsequent slow recovery. Policies of austerity in Europe have stalled expansion and, as a result, energy consumption. A volatile Japanese economy has reduced oil consumption in economically developed Asia by 0.13 million barrels per day. Brazil, a developing economy, is struggling to reach even 1% growth in GDP. Even China, largely unaffected by the economic crisis, has lost momentum. The once bullish 14.7% growth in 2007 has fallen off, currently sitting at 7.2% and slowing. For months, economists have been pointing to warning signs of another economic crisis on the horizon if governments do not take a more proactive role in increasing growth. Crude oil futures, in turn, have dropped dramatically since June. Oil, undoubtedly, is losing its power as a commodity on the global marketplace.

The surge in American LTO production, a change in Saudi strategy, and slower-than-expected growth in consumption led to the reduction in WTI prices since June. These shifts—combined with the continued trend towards alternative energy and the growth of coal as an energy source in Asia—have shaken up oil’s place in the energy sector. Moreover, the geopolitical climate that has for decades revolved around energy is now changing at a pace no one could have anticipated.

Already, the diplomatic effects of the market shift are coming to fruition. Russia, whom Deutsche Bank estimates requires a price of $100 per barrel to break even on its governmental budget, is certainly feeling the pressure of faltering energy prices. Energy exports account for 25% of GDP and foots the bill for nearly half the government’s annual expenses. The dramatic drop in prices, then, has been a wake up call to Putin, whose policies have led to a projected economic growth of only 0.4%.

As the Kremlin’s budget for 2015 was being planned out in October, expected increases on spending came under fire. “You know that energy prices have fallen as well as for some of our other traditional products,” admitted Putin to a government panel. “Due to that, would we not, on the contrary, reconsider the budget toward reducing some spending?”

Preferring to hope for the best, Russian parliament approved a budget draft keeping spending levels in-line with the $100 per barrel it had required before the price collapse. To this, finance minister Anton Siluanov responded that “the budget can not constantly have expenses that were made at different economic reality.” To make matters worse, the Russian government is already locked into spending over $50 billion hosting the World Cup in 2018.

Putin has already vowed no increase in taxes, citing the country’s reliance on the private sector for growth. Closing off this last resort to increase revenues, the Russians will be forced to decrease spending. Defense expenditures may be the first to get cut back. A 10-year $770 billion rearmament program scheduled to begin in 2015 will almost certainly be shelved again as it was when the first sanctions over Ukraine were put into place last spring. Putin may also be made to retract his ambitions in Ukraine if oil prices stay below the $100 per barrel threshold, though many argue the Russian president is willing to bury the country in debt to save face and hold the line. In any case, an increasingly faltering Russian economy will make the removal of sanctions an attractive bargaining chip and strengthen the West’s hand in negotiations over Ukraine.

Iran, too, is seeing its diplomatic options narrow with dipping oil prices. Even a month ago, it was widely thought the US had too liberally reduced sanctions over Iran’s nuclear program, eliminating any Iranian motivation for a deal to be struck this fall. This no longer appears to be the case.

Deutsche Bank has placed Iran’s particular budget-balancing price point well north of any other exporter’s estimate, claiming president Hassan Rouhani would need crude prices at $140 per barrel to operate in the black. If the $110 average in early summer was cause for concern, the drop to the current $80 per barrel is cataclysmic.

Where in the past officials could claim the Iranian economy would be able to survive even if a long-term sanction-relieving deal could not be reached, the current oil crisis has undermined the reality behind their assertions. Jamshid Edalatian, serving on the chamber of commerce in Tehran, is quoted as saying, “Oil prices are bound to go down even further, and already the government faces big financial shortcomings… We need this nuclear deal, or we will face very hard times.” When negotiators meet in November, American officials will again have the upper hand.

Iran and Russia are not the only crude exporters being forced to re-examine strategy for a world in which oil will play a smaller and less-expensive role. Nigeria, Ecuador, Algeria, Iraq, Angola, and Libya are all being forced to sell crude at essentially bankrupting prices. On October 11, Venezuela called an emergency meeting for the organization that binds many of the major exporters together, OPEC. As oil prices continue to fall, the organizations very future appears at risk, or at least unclear.

OPEC assumed power in the energy market when it set a cap on total aggregate oil production within the organization and steeply raised prices in response to the 1973 Yom Kippur War. It’s production quota today of around 30 million barrels per day carries enough influence in the market— around 45% of total world supply— that changes in output ceiling can greatly influence prices by either constricting or flooding global supply.

Today, though, the organization is beginning to resemble more a paper tiger than a legitimate challenger to the low prices brought on by the oil glut. While the Saudis can stay afloat while running a deficit for at least the near future, members like Venezuela, where mismanagement and overspending have racked up billions of dollars in foreign debt, are demanding that OPEC make policy changes to drive prices up. In Iraq, low prices have become unacceptable to a government barely managing to hold off the Islamic State’s assault. Nigeria, too, faces pressure from within in the midst of an election year to raise oil prices. But as internal divisions continue to prevent consensus on strategy, Venezuela and its allies’ pleas for constricted supply remain unlikely to be answered.

Politics, as much as budget problems, are behind the divides within OPEC. The turmoil of the civil war in Syria lead to tension between Saudi Arabia, who backs the rebels, and Iran, who supports Bashar al-Assad’s regime. These two rivals represent the lion’s share of production within OPEC, pumping a combined 13 million barrels per day. The decision by Saudi Arabia to sell at lower prices rather than cut back production was made all the more easily knowing Iran was to lose from it. “Iran is very vulnerable in the oil sector, and it is there that more could be done to squeeze the current government to join the world efforts toward peace,” said Saudi prince Turki al-Faisal shortly after WTI prices began to plunge in June.

OPEC as an organization derives its strength from acting in unison. Though countries have always cheated on production quotas, a group motivated by a similar goal of price control has kept production near set ceilings for decades. But when countries simply cannot afford to operate at OPEC approved production ceilings, they must defy them. If OPEC secretary general Abdallah el-Badri cannot persuade members to adhere to a unilateral strategy when members meet on November 27 in Vienna, defectors from the organization may begin to arise.

For some countries, this might be the only option.

It would be an understatement to call the collapse in crude oil prices since June a watershed moment in energy. What, just months ago, seemed like a world where Americans would be at the whim of the middle-east for as long as we relied upon oil now seems like one where American energy independence is a goal not for future generations but for the next decade. Already, since the shale oil boom began in 2008, OPEC oil imports to the US have been halved. More American capital than ever is being reinvested in the country instead of flowing into foreign coffers, and growth in the energy sector is leading to a resurgence of American innovation.

Yet, with all these seemingly boundless benefits so close to home, it would be prudent to remain aware of their ultimate cost: the environment. Although the International Energy Agency expects total oil consumption in economically developed countries to decrease at accelerating rates even with decreased prices, the transition to alternative energy isn’t happening fast enough. Fuel-efficient cars will only get us so far; a total shift away from fossil fuels is not just a recommendation. It’s a requirement to ensure our future.

When Republicans take control of both houses this January, a political agenda centered around strict oversight of the EPA will certainly push back against recent environmental strides. With cheap fossil fuels on our doorstep from now on, it may take more than economic necessity to drive renewable energy forward. We will need moral resolve –and lots of it.