Since July 2014, crude oil has fallen steadily from $100 per barrel to its current price of about $55 per barrel. Much of the price decline has been driven by OPEC's strategy of creating an oversupply situation in order to deliberately drive prices down and stifle US shale production. Here’s how it all works: daily global oil demand is about 90 million barrels per day. The 12 member states that make up the OPEC cartel produce about 30 million barrels per day – that is about 33% of global oil production. What makes OPEC especially powerful is that the cartel also controls about 80% of all of the proven oil reserves in the world. By coordinating production and adding or withdrawing capacity, OPEC is able to drive oil prices in whatever direction it wants. If prices are too high with the attendant risk that economies can slow down leading to medium to long term overall reductions in energy demand, OPEC adds capacity to the market, and the excess supply helps to bring prices back down. When prices are low, OPEC withdraws capacity and drives prices back up. For years, this simple supply driven strategy has worked, and it helped to drive oil prices up from about $40 per barrel at the depth of the 2008-2009 recession, to about $90 - $110 per barrel from January 2011 to July 2014.
Why then has OPEC changed its strategy from one that is focussed on driving up oil prices to one that has driven oil prices down by about 50% within a six month timeframe? The answer lies in the quiet Shale oil revolution that has been occurring in the United States. Since 2008, domestic US oil production has increased from 5.5 to 9 million barrels per day, with almost all of the growth coming from hydraulic fracturing based shale oil production. In that timeframe, Canada has added another 1 million barrels per day to global capacity from its oil sands fields – much of which has ended up for sale in the US. The US consumes about 18.9 million barrels of oil per day, and the 4-4.5 million barrel per day increase in domestic North American production has displaced an equivalent volume of oil from mostly OPEC countries. This loss of market share is what is driving OPEC crazy.
By most accounts, Nigeria has so far lost 100% of its US crude oil market. From a high of about 1.3 million barrels per day (out of about 2.2 million barrels per day of total production) of sales to the US in 2007, Nigerian light crude has now been completely replaced by shale derived crude oil locally produced in the US. Although some of the market loss has been offset by sales to buyers in Asian countries like China, Malaysia and India, Nigeria is still struggling to find new, long term markets for its crude. US Shale oil is of the light, sweet crude variety which especially makes it an excellent replacement for light crudes from OPEC countries like Nigeria, Libya and Venezuela.
OPEC’s current actions are intended to drive prices so low that existing US Shale producers will be forced to fold up, while the backlog of projects waiting to come on stream will be either indefinitely postponed or cancelled outright. Breakeven oil prices for US Shale formations range from about $20-30 per barrel in the Marcellus and Utica shale basins, to $40-60 per barrel in the Eagle Ford and Niobara basins, and $60-80 per barrel in the Bakken and Barnett basins. If OPEC sustains prices in the $40-60 range, some US shale producers will likely be driven out of the market place in the short to medium term.
There are four factors that make OPEC’s market recovery strategy questionable. Firstly, since the start-up and exploration project costs for the operating shale wells have already been spent (or sunk, in project finance parlance), it makes more sense for production to continue. Yes, breakeven projections and profitability expectations will be upended but production will likely continue nonetheless in many fields that might seem to be unprofitable on paper. Secondly, not all OPEC nations can bear low prices for a prolonged period, and countries like Nigeria with fragile economies and relatively high crude oil production costs ($20-40 per barrel) cannot afford to hinge their national economies on a roller coaster thrill ride powered by nations like Saudi Arabia – that have very low crude oil production costs ($4-10 per barrel), and well thought out strategies that plays to their strengths. Thirdly, the strategy assumes that there will be no response from the US to OPEC’s frontal assault on North American shale oil production. America is in the middle of an intense national debate about the role that the shale boom can play in helping to secure energy independence. The benefits of increased local US production on the American and global economy are already self-evident. In 2008, attacks on Nigerian oil infrastructure by the militant group MEND, sent oil prices rocketing towards $120 per barrel. Today, America does not need a drop of Nigerian oil, and oil supply has been systematically moved towards relatively stable North American sources. The global economy has also been able to ride significant events like ISIS’ sweep of Iraq and Syria based on the increased production coming from the immensely stable North American market. It is possible that the overriding National security interest of ensuring stable oil supplies could drive the US to consider providing subsidies of sorts to the fledgling shale industry. For instance if the US provided subsidies of about $10 - 20 per barrel to Shale oil producers who currently generate about 4 million barrels per day on aggregate, the annual cost of such a policy would be about $16 –32 billion per annum – a paltry sum in the grand scheme of things for the $17 trillion US economy. Fourthly, OPEC has little leverage, and certainly no control, over almost 70% of global oil production, i.e., about 60 million barrels per day of crude oil produced by non OPEC players like Russia. While the ability of the non OPEC players to swing production capacity is limited, there is no way of telling what their response will be to any attempts that OPEC eventually makes to pull back production and drive prices back up. Russia is reeling from an economic crisis and might want to make up for its significant losses by trying to maintain high production output.
Focusing on Nigeria – based on the 2015 budget of N4.358 trillion ($ 26.4 billion) recently presented to the national assembly by Ngozi Okonjo Iweala, the coordinating minister for the economy, oil based revenue contribution is expected to be N 1.918 trillion ($11.6 billion). This is based on an assumed production capacity of 2.28 million barrels per day at a sales price of $65 per barrel, and an exchange rate of N165 to the dollar. Non-oil revenue contribution for 2015 is estimated to be N1.684 trillion ($10.2 billion), and the ensuing budget deficit will be about N756 billion ($4.58 billion). Assuming the non-oil sector revenue targets are met, the oil price required to ensure that Nigeria meets all of its fiscal obligations without running into deficits is about $75 per barrel. If oil prices were to drop any further, say to about $45 per barrel, Nigeria’s budget deficit will be about N2.4 trillion ($14.57 billion).
Saudi Arabia can afford to play the low price game for much longer. With crude oil production costs estimated to be in the $4-10 per barrel range – the lowest in the world – the Kingdom will keep making profits even if oil prices were to drop as low as $20 per barrel. Saudi Arabia also sits on a sovereign wealth fund that is estimated at about $740 billion, that provides it with sufficient leverage to ride out vagaries in the global oil markets.
There are already rumblings in the ranks of OPEC about the current strategy. Iran and Venezuela have previously questioned the sustainability of the Saudi driven strategy, and their ranks have now been joined by Algeria, which has already had to declare austerity measures by freezing all public sector hiring for 2015.
Nigeria on the other hand has been silent on what its short, medium or long term strategy is. While all other OPEC members have been voicing off on their views regarding the Saudi driven strategy, and in the case of nations like Iran and Algeria – openly dissenting with the Saudi position, the Nigerian point of view has not been articulated. It is not clear if one has even been formulated. The only OPEC related news that has made the rounds in Nigeria was the announcement that Diezani Alison- Madueke, the current Petroleum Minister was elected to the Presidency of OPEC.
Nigeria will need to come up with a four pronged strategic plan that addresses the following areas: (i) articulating a short term tactical approach to the current pricing regime that ensures that current and future fiscal obligations are met in a responsible way (ii) finding new, stable and profitable markets for the current output of crude oil (iii) reducing the dependence on external markets by enhancing internal refining capacity within Nigeria, and (iv) creating a strategic playbook that will guide the nation’s engagements in the global oil markets either individually or through OPEC.