What Is OPEC and How Does It Affect Oil Prices?

Image source: Getty Images. 

When OPEC speaks, the oil market listens. While it cannot control the market price of oil, it can influence its direction. This impact leads to some pretty wild swings in oil prices, which then affect the profits oil companies' earn from production.  

A brief history of OPEC

The Organization of the Petroleum Exporting Countries, or OPEC as it is more commonly known, was founded in 1960 by Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela as an intergovernmental organization. Nine other nations later joined: Qatar (1961), Indonesia (1962), Libya (1962), United Arab Emirates (1967), Algeria (1969), Nigeria (1971), Ecuador (1973), Gabon (1975), and Angola (2007). Ecuador, Indonesia, and Gabon dropped out for several years before rejoining in 2007, 2015, and 2016, respectively. 

OPEC's purpose is to:

Co-ordinate and unify petroleum policies among member countries, in order to secure fair and stable prices for petroleum producers; an efficient, economic and regular supply of petroleum to consuming nations; and a fair return on capital to those investing in the industry. 

While OPEC's objective is to maintain order in the oil market, that has not always been the case. The most famous example is the Arab oil embargo. In Oct. 1973 a group led by the Arab majority of OPEC, as well as non-members Egypt and Syria, declared a steep cut in oil output and an oil embargo against the U.S. and other nations that supported Israel in the Yom Kippur War. This led to a sharp increase in oil prices, from $3 to $12 per barrel, causing panic and a period of energy rationing.

How OPEC affects prices

In addition to production cuts, one of the levers OPEC uses to impact prices is production quotas. In 1982, OPEC introduced mandatory quotas among its member nations to control supplies. In doing so, it became a price-setting cartel instead of a group of price-taking commodity producers. That said, OPEC has not always gotten these quotas correct, which has had the opposite of the desired impact on prices. For example, in the late 1990s, it misread the market by raising its production ceiling 10% without taking into account the impact to demand from the Asian financial crisis. This caused prices to plunge, forcing OPEC to lead three rounds of production cuts to get the market back into balance.

More recently, OPEC pushed its output higher to push down prices. This marked a notable shift in strategy, with OPEC members going from protecting oil prices to protecting their share of the oil market.

This change is partially in response to rising production from non-member nations, including surging production from U.S. shale, the Canadian oil sands, and offshore sources. However, the decision destabilized the oil market and led to tremendous oil price volatility.

The market's current instability causes a swift reaction to news that OPEC might shift away from this strategy. For example, in early 2016, OPEC held meetings with non-member nations Russia and Oman to discuss a production freeze. Those meetings helped fuel a fierce rally, with oil prices rebounding 50% off the bottom. However, the groups failed to strike a deal because not all members were on board. That said, the talks alone had the desired effect of pushing prices higher.

Image source: Getty Images. 

How OPEC impacts oil companies

Before the recent collapse in crude prices, there was a generally held belief that OPEC wanted crude to stay above $100 a barrel. While OPEC never officially sets a target price for oil, many of OPEC's member nations need a certain oil price to balance their budgets. For example, according to the International Monetary Fund, Saudi Arabia needs oil to average $106 while ING Bank data suggests Ecuador, Nigeria, and Venezuela need oil above $120 a barrel.

This belief that oil would stay reasonably stable led oil companies to make huge bets on large oil projects. For example, big oil behemoths Royal Dutch Shell (RDS.A) (RDS.B), ExxonMobil (XOM 0.14%), and Total (TTE 0.43%), along with several international partners, invested $50 billion in developing the Kashagan oil field in the Caspian Sea. While Kashagan is considered the largest oil discovery in the last 30 years, it requires high oil prices to break even. According to the chairman of KazMunayGas, one of the partners in the project, Kashagan "can be economically viable with oil prices standing at $100 per barrel." That said, another industry source stated that Kashagan would cease to be profitable at $80 oil. 

Either way, the project has been a debacle for Exxon and Shell, which own a third of the project that they initially expected would cost $10 billion and be on line in 2005. However, after several delays, the project still isn't producing any oil, and when it restarts later this year, it could take five years before it reaches profitability. It is a project that Exxon, Shell, and Total likely would not have pursued if they did not expect OPEC to keep oil prices stable over the long term.

Investor takeaway

OPEC has both been a blessing and a curse on the oil market. When it provides stability, it emboldens oil producers to make investments for the future. However, when OPEC changes course, it can have a devastating impact on producer profits.