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The Decline of OPEC and What It Means for Oil

By Jay Yao - Feb 6, 2014 at 1:16PM

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Are the times changing for the world's most powerful cartel?

It is the world's most famous cartel. OPEC currently controls almost three quarters of the world's crude oil, a commodity that, as of right now, industrialized nations cannot do without. 

Ever since the 1973 Arab oil embargo when the cartel caused global oil prices to quadruple, the twelve nation group has been the judge, jury, and executioner for global oil prices.

Due to a variety of conditions, however, OPEC's future may not be as bright as its past. 

A slow decline
In an effort to maintain high oil prices, OPEC has a crude oil production ceiling of 30 million barrels a day. 

The cartel's ability to maintain its quota going forward seems tenuous. . 

Because of the shale revolution, the United States is importing a lot less oil. According to the EIA, U.S. oil production increased to a 25-year high last year. The United States produced more than 8 million barrels of crude oil a day last December, while its net crude imports fell to around 7.5 million. The EIA projects that the United States will import only a net of 6.57 million barrels a day this year. 

Another factor disrupting OPEC is the prosperity paradox. The prosperity paradox says that the more people prosper, the greater the expectations for themselves and their children and the greater the possible discontent. 

The paradox, in addition to wider usage of social media and rising food prices, played a major part in fomenting the Arab Spring in late 2010. 

While the Arab Spring has faded away, the expectations of a better life in OPEC countries have not. In response to the Arab Spring, many OPEC nations have increased their generous social welfare programs. These programs, along with increases in population, have put a deep strain on OPEC's finances. To maintain their fiscal budgets, OPEC nations need either increases in Brent crude prices or increases in oil production. Since Brent seems range-bound, OPEC will likely need to pump out more oil going forward.

Another stressor to OPEC is Iraq and Iran. Due to geopolitical troubles, Iraq and Iran have not contributed their share in terms of production versus reserves. This is likely to change. If Iraq can keep out of civil war, it is on pace to produce almost as much oil in 2020 as Saudi Arabia does today. Iran is also likely to increase exports immensely if sanctions end. 

The bottom line
In my opinion, like many other things in the world today, OPEC's future depends on how China's economy does going forward. If China grows at its predicted rate, crude oil prices will be high enough to finance the cartel's social programs and OPEC can continue to maintain its cohesiveness. 

If OPEC doesn't keep its discipline and increases production dramatically, oil service companies such as Schlumberger (SLB -1.53%) and Halliburton (HAL -1.26%) will win. The more OPEC production, the more business the oil service companies will receive. Out of all the service companies, Schlumberger is one of the most international. Schlumberger currently generates nearly 70% of revenue outside North America. 

U.S. refiners such as Valero (VLO -1.47%) will see fewer benefits because increased Brent production means that the Brent-WTI spread will likely narrow. Currently, U.S. refiners are benefiting immensely from the wide spread because they are using cheap WTI as feedstock while their competitors are using more expensive Brent. 

I don't think the fraying of OPEC means lower oil prices in the long term; apart from some places in the Middle East, the easy oil has long been drilled and the cost of production is much higher than before. It does mean, however, that there will likely be more geopolitical events in the future as welfare states fail to subsidize their social programs. The more geopolitical events, the higher the risk premium for crude oil.

 

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