Paris Climate Accords, Shale and Implications for OPEC

Since the 1980s, the Organization of Petroleum Exporting Countries (OPEC) has operated from the assumption that someday in the future (for years, viewed as by the 2010s), the industrialized world would use up its “easy” oil and become increasingly dependent on OPEC and in particular the vast reserves of the Middle East. In this world, OPEC’s petro-power would increase over time and therefore all the oil cartel really needed to do was wait it out for that day to come. An econometrics study by New York University economist Dermot Gately in 2004 confirmed the view within OPEC that “the (revenue) payoffs to OPEC are relatively insensitive to faster output growth.” Through the 2000s and up until last year, OPEC took a revenues oriented strategy, believing that the “2010” world had arrived and its oil was more valuable under the ground than out in the market.

But the U.S. shale boom and this week’s Paris climate accords have changed the world in which OPEC operates. Now, with the prospects that major economies like the United States, China and Europe will actively try to shift away from oil and the costs for producing oil from shale and other source rock will decline through technological innovation and learning over time, producers are coming to realize that oil under the ground might someday soon be less valuable than oil produced and sold in today’s market. In effect, perceptions have changed from believing a peak in supplies was possible to believing a peak in demand for oil is possible over the next several decades.

OPEC’s decision to end its December 2015 meeting with no production ceiling has rattled markets and strengthened “lower for longer” sentiment. Pessimism about December OPEC meeting was briefly interrupted by a garbled rumor that Saudi Arabia would float the possibility of an OPEC-non-OPEC agreement to cut production. For its part, Iran refused to consider any commitment to cut production until it restores its output after the removal Western sanctions, likely to be lifted in the next six months if the completed agreement on Iran’s nuclear program proceeds. A six month delay suited many OPEC members (including notably Saudi Arabia) who feel the current market share strategy is succeeding to knock out investment in North American production and will eventually stimulate a tangible recovery in oil demand. As demand recovers in 2016 and non-OPEC production declines, market conditions will be more conducive for an effective OPEC-Non-OPEC agreement that will raise prices, so OPEC thinking goes.

But the long-term future painted by the Paris climate accords may mean market conditions conducive for producer cartel action may not be sustainable, if they come at all in 2016. If and when markets become more confident in the concept of peak demand, investment and production strategies will need to be adjusted, not just among private companies, but within OPEC itself. That means even if markets tighten in 2016, players will have to think twice about delaying the development and production of reserves, lest they disadvantage themselves over the longer time horizon. Only parties that have no choice (lack of finance, geopolitical barriers, inability to organize investment due to bureaucratic failures, etc.) will be left out of the calculation whether to consider the remaining “carbon budget” for global oil production in deciding how much and when to invest to monetize current reserve holdings ala Norway’s decisions in the decades prior to the millennium.

OPEC members and international oil companies may choose to believe that a peak in oil demand won’t come at all. That would certainly be more convenient for them and forecasts like the International Energy Agency do project gigantic increases in oil demand in countries across ASEAN and the Middle East. But Saudi Arabia and Russia have more than a century of oil left under the ground if one counts now produceable layers of shale and other source rock. This realization, coupled with the trend lines confirmed in Paris, could worsen the geopolitical conflict between the two which is already encouraging both parties to consider going for broke in the war in Syria.

Right now it is assumed that at some low oil price number some other party (shale, oil sands, deepwater Brazil, etc. ) will fall out of the market share game and leave room temporarily for the two oil production superpowers – Saudi Arabia and Russia – to divvy up more comfortably what’s left. But whatever price recovery does eventually ensue would presumably be relatively short-lived, as other higher cost producers are likely to find ways to reenter markets re-stabilized by any OPEC-non-OPEC pact, only to create the same market share competition dynamics over and over again. And hedging muddies the timed response for players to exit and enter the investment cycle. Only the more permanent elimination of a major player, such as seen with the destruction of governing institutions in Libya, would solve the problem for a time – a dangerous reality for the current proxy wars in third countries.