The oil cartel is divided in its response to increase US shale oil production.

STEVE AUSTIN | 2013/07/01

Previously on OIL-PRICE.NET, we've looked at reasons for lower bound of oil prices. With questions asked from our readers, we've decided to take another look with special emphasis on OPEC. For, OPEC is an important factor in the 'price setting' feature of oil industry. Yes, it sets the tune of oil prices for its member nations, which export oil. Following the lion, other non-OPEC nations are also happy to sell at that market price

Therein, here's a starter to bust one of the above. Supply? So, more the oil, lower the prices, right? Wrong.

Before wading in, what is OPEC? OPEC is an intergovernmental organization with twelve oil-producing countries. And why is it so important? Based in Vienna, OPEC is responsible for about forty percent of the global oil production. It decides production quotas for its member countries. So, it can cut production when prices fall and vice versa. The oil cartel says its mission is to 'coordinate and unify the petroleum policies of its member countries and ensure stabilization of oil markets' so that there is 'efficient, economic, and regular supply of petroleum to consumers'. Does it, now?

Last month at Vienna, OPEC decided to keep the production quota of 30 million barrels a day (bpd) unchanged. With the Brent Crude oil, it came as little surprise. In fact, OPEC's current ceiling has been in place since 2011.

With the economic slowdown, the oil prices are, indeed, higher for many consumers. But is it too much? Not in the opinion of OPEC's secretary General Abdullah Al-Badry, who feels that ultimately the price at gas stations is due to taxes. He says, "If governments want to do something for their economy, they should reduce their taxes." But of course if the prices fall, the Secretary General opined they would hold an emergency meeting to reduce output. How ironic. But then, you wouldn't be mystified if you look at the history of OPEC. For instance: In the later part of 1973, few decisions taken by OPEC like production cutbacks, embargo on shipments to select markets and charging more from the oil companies resulted in oil prices increasing about three times in 1974 compared to the previous year. Many analysts still blame OPEC for the peak oil prices in 80-81.

Why has OPEC maintained the status quo of production quota for its member countries?

OPEC has reasons to be wary. The shale oil production in the US, thanks to hydraulic fracturing and horizontal drilling in Texas and North Dakota, is rising as we speak. Last month, the world's biggest economy had about 7.4 million barrels of shale oil per day-total output. The IEA estimates the shale oil production in the US to top 9 million barrels a day by 2018. Also, production in Canada has seen an upsurge in recent times. Since the US is one of the main markets for OPEC, the increasing energy production here is definitely a headache for the oil cartel. Naturally, many of the OPEC countries are unhappy over the increasing oil production in the US.

Up until now, the world's market price for oil was contingent to the OPEC-set minimum price. As seen above, things have changed sending jitters. By 2015, the spare oil capacity of OPEC could increase to more than 6 million bpd. So far, OPEC hasn't acknowledged the shale oil production in the US as a threat to its income. Yet, the member countries are divided on the issue.

Some countries in the oil cartel like Iran, Venezuela and Nigeria have been quite vocal on their need for oil to remain above $100 a barrel. According to EIA, three of OPEC members from Africa, Nigeria, Algeria and Angola, with oil similar in grade to US shale oil, have seen export to the US fall by about 41 percent from 2011 to 2012. All three, though, denied being concerned about shale oil. And, the country with the second largest oil reserves in the world, Saudi Arabia considers the increased oil production in the US as a 'welcome addition' to the world. As the Saudi oil minister stated, "This is not the first time new sources of oil are discovered, don't forget history". It has, on the other hand, cut production by 600,000 barrels a day compared to a year ago, to 9.3 barrels a day. In the case of Iran, the production dropped by 400,000 barrels a day, mainly due to embargoes placed because of its nuclear ambitions.

Over-supply of oil will drive the price of crude towards the downward slope in the world market. And if oil prices fall below the OPEC set minimum price, the oil cartel will cut down production, as seen earlier. Of course, there are already two camps: Those that can afford to cut production like Saudi Arabia and UAE and those that can't like Venezuela, Algeria and Angola. An important factor that has, so far, played itself for the OPEC is the unity of its members. Greater tension within the member nations, some of which are ruled by dictators averse to compromises, could undermine the lobbying power of the cartel. Further, if the group disagrees and splits, OPEC influence in the world stage will diminish forever.

Anyway, OPEC's Secretary General has said that the cartel would study the effects of shale on the member countries. Could this division fester more? If so, the monopoly and lack of competition will come to an end. Signs on the wall read that the days of OPEC helming the oil market are drawing to a close.

Some of the OPEC member countries like Nigeria and Algeria are already concentrating on Asian markets like India and China. Iraq is in the fray too, though poor infrastructure in the country has hindered exports. Iraqi oil minister expects his country's oil production to increase up to 3.5 million bpd by the end of 2013. Still, with China discovering shale in its backyard, it remains to be seen how the move would benefit them in the long run.

The Arab spring, according to IEA, has taken a toll on investments and capacity growth of several oil producing countries. OPEC estimates demand for its oil shrank by 400,000 barrels a day this year. If global demand recovers, the supply would come from non-OPEC countries including the US. Definitely, not a very happy scenario for the OPEC members.

So why is US importing oil-still?

So we know the monopolist days of OPEC may be over. Would US act as a catalyst? There's a catch, in fact, two. At present, US still imports heavy and medium grade crude for the refineries in the Gulf of Mexico from Saudi Arabia and elsewhere.

Why? Yes, due to domestic refineries which are adapted to process heavier crude. But the most important reason is due to some old laws. Export of domestically produced crude oil is banned under the Energy Policy and Conservation act 1975, the Mineral Leasing Act of 1920, the Outer Continental shelf Lands Act Amendments 1978 and Naval Petroleum Reserves Production Act. The most important of these acts is the Energy Policy and conservation Act brought about when production of crude was decreasing in the US. The act also set fuel standards for vehicles, set up the strategic Petroleum Reserve and extended oil price controls.

Things have changed since the seventies, you'd think, but the export ban has stayed. The US imports light sweet crude from Africa. US domestic production is also light sweet crude which isn't suitable for US refineries which are tuned for processing heavier and sulphurous oils of lower value. The domestic production of lighter oil has lower sulphur content and greater value. If Keystone Xl pipeline becomes operational, the country would be deluged with medium and light crude. Why not just export the surplus? If keeping the oil at home, away from any outside influence, is sound, then we should have had cheapest oil in the world at the pump station. It makes commercial sense to export crude when there is record production which the local refineries are unable to process, right? North America's oil is expected to amount to about 50% of global output between 2012 to 2018, according to IEA and OIL-PRCICE.NET. That's oil! Well, the demand for oil and gas in the US is estimated to 'steadily decline' between 2012 and 2018, so where's the market for oil? Whereas, as per IEA estimates, the global oil demand is expected to rise 8 percent between 2012 and 2018 to reach 96.7 million barrels a day. You can do the math.

If all net crude distillation capacity growth is expected to take place in the emerging markets, it makes economic sense to send oil there, or not? Would the US be napping when it overtakes Saudi Arabia as the world's biggest oil producer by 2020? Why not review or repeal the Energy Policy and Conservation Act? There is the question of natural gas too. Natural gas is an important energy source for industry as well as household. Indeed, the significant factor in the US energy scene has been the cheap and abundant natural gas. There are hurdles too. According to some policies of the U.S. Department of Energy, natural gas can't be exported to countries that do not have a free-trade agreement with the US (Or pending approval from Department of Energy). So there are only 18 countries to which US exports can reach. Why the allergy to foreign markets?

Meanwhile, OPEC has cut its estimate of the demand for its crude and stocks in 2017 to 29.99 million bpd down by 1.22 million bpd from previous estimates. So, expect lobbying dollars to flood Washington from OPEC countries to keep the ban in place. Thus should the Energy Policy and Conservation Act be repealed, expect a new floor price for the price of crude, not set by OPEC this time but by free markets.

There is more than just money at stake for OPEC. Should control over the lower bound of oil prices slip out of OPEC's hands, expect uprisings and unrest in the UAE Qatar and the Saudi kingdom. They are being held together by generous public programs paid for by oil, but if the oil price drops below, $70 a barrel (cost of funding welfare programs), these states will go bankrupt and headed the same way as Libya, Syria and Tunisia (Check: http://oil-price.net/en/articles/lower-bound-of-oil-prices.php ). So far, in the oil game, points to OPEC for 'well played'. So as the status report goes: Game on.