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OPEC Is Finally Starting to Fret About Oil Prices

By Matthew DiLallo - Sep 6, 2015 at 8:42AM

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OPEC worries that there is no short-term fix, which could lead to an even bigger long-term problem.

Photo credit: Day Donaldson via Flickr.

As the oil downturn enters its second year, OPEC is finally starting to worry. In a market commentary issued earlier this week, the organization said there were "no quick fixes" for the current low-oil-price environment. This is a concern for it and the entire oil industry, as profitability will remain weak in the short term, while there could be longer-lasting consequences if oil does stay lower for longer.

Short-term pain for producers
Much of OPEC is having a tough time with the oil-price weakness. Several nations are running big budget deficits while Venezuela's economy is in shambles, as the drop in oil prices has taken away the lifeblood of its economy. That's why it is reported to have recently requested an emergency meeting in an effort to coordinate a production cut in an effort to spur oil prices. However, before such a meeting were to take place, it would need other non-OPEC nations, namely Russia, to coordinate a production cut with the group.

Even OPEC's largest member, Saudi Arabia, is feeling the pinch of lower oil prices. It's softening the blow by using its foreign currency reserves as well as its first sovereign debt issuance since 2007 to patch a hole in its budget that has been widening as oil prices continue to remain weak. However, it can't cover that gushing wound forever, as one model predicts that it will run out of cash in its reserve fund by August 2018 at its current burn rate if oil stays around $40 per barrel. Meanwhile, poorer OPEC nations such as Libya, Iraq, and Nigeria could be joining Venezuela in turmoil if oil does stay lower for longer. Clearly, there is a near-term motive for OPEC to act before real damage is done to member nations' finances. 

Longer-term pain for consumers
Having said all that, there is an even greater long-term risk to the global economy from the lower oil prices of today because of the lack of investments being made in non-OPEC production during the downturn. Oil companies around the world are deferring and canceling expensive long-term oil projects that are needed to meet future demand. These projects will be needed because the depletion of oil reservoirs means that global oil production declines at a 4% rate per year, while demand has been increasing by roughly 1% per year because of economic and population growth. We can see this dynamic on the following chart from a Chevron (CVX 0.96%) investor presentation.

Source: Chevron Corporation. 

In other words, there will come a point in the not so distant future where there might not be enough new oil production coming online to meet demand growing demand, which has been accelerating because of lower prices. This situation has OPEC really worried.

OPEC said that "failure to invest now could mean prices in the coming years spiking to levels inconsistent with what is considered 'reasonable' for both producers and consumers." This statement echoes an earlier warning from Secretary-General Abdulla al-Badri, who said oil prices could explode to as much as $200 per barrel in the future if the industry continues to defer investments in mega-projects such as ultra-deepwater and oil-sands projects.

To date, oil companies have deferred more than $200 million in investments because of the oil-price crash, according to a report by Wood Mackenzie. This deferral represents as much as 10.6 billion barrels of oil equivalent resources that won't come online as early as planned. Chevron, for example, has already halted its plans to drill in the Canadian Arctic while also delaying its $12 billion Indonesia Deepwater Development project. More delays could be on the way, as Chevron's Canadian LNG export project at Kitamat is at risk of being further delayed, as is its $10 billion North Sea Rosebank project, while many of its peers will probably also delay additional multibillion-dollar projects should oil prices continue to remain weak. That puts a large portion of potential future supply at risk.

Investor takeaway
While OPEC has said it can withstand weak oil prices for a couple of years, it's beginning to worry that it might not have that much time because of the long-term implications of lower prices. Its intention was to force its competitors to cut near-term investments so it could maintain its market share without having to cut its production. However, the opposite has occurred, as many oil companies are focusing on near-term growth to boost production and therefore cash flow, while axing longer-term projects. That situation could lead to a major future oil-price spike, as investments not made today will lead to lower supplies a couple of years from now.

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