OPEC DEAL AND OIL PRICES

The Organization of the Petroleum Exporting Countries was created in 1960 to coordinates the
energy policy of member countries who produces about a third of the world’s oil. They try to
regulate the world oil prices by setting quotas for its members which are raised when oil prices
are high and are lowered when oil prices are low. On November 30th 2016, OPEC members led
by Saudi Arabia pledged a cut of 1.2 million barrels per day from global oil production with non-
OPEC member like Russia also chip in a further 600,000 barrel cut per day. The above cut has
taken effect from 1stJan 2017 and will last for six months.
With the above background, I will analyze how does the OPEC’s agreement of regulate
productions impact the world oil prices in the short and long term.
The law of supply and demand affects the oil industry mainly through its price determination of
oil. The demand for oil is relatively inelastic with respect to prices given that oil has few direct
substitutes.

China is the largest importer of oil as evident from the above chart. Demand is growing in
advanced, OECD and much faster in developing countries like China and India. In advance and
OECD countries, demand of oil is relatively inelastic with respect to income. While, income
elasticity of demand is higher in developing economies like China and India. Given that demand
of is relative income inelastic and there are very few commercial viable substitute in the short
term, OPEC has significantly influence on the price of oil in the short term. This can be evident
from the surge in prices with the announcement of OPEC cut (refer to the following graphs).
Crude prices surges as OPEC cuts kicks in

This has not happened only this time (OPEC Cut announced in Nov’16) but also in the past.
Historically, prices of oil have surged in the immediate aftermath of OPEC agreement to cut
production (in 1998, 2001 and 2008). This is evident from the following graph.
However, in the long term, OPEC ability to influence the price of oil is limited because high oil
prices for a sustainable period impacts the consumers’ / industries’ behavior and provide
different incentives to individual countries to stabilize the oil prices.
The current price and expectations of the future price are major factors which determines how
investors in the oil industry allocate their resources. On the supply side, high oil prices lead to
higher investments resulting in more drilling and exploration projects giving rise to higher
capacity / productions in the long run. Company spend more money in research leading to
innovation in techniques and efficiencies. Many projects that were not viable at lower prices may
become viable when prices are high. These all activities therefore increase the supply. During the
period of high oil prices (around $100 per Barrel during 2008 and 2014), substantial investment
poured in oil production in franking and oil sands. This resulted record production in 2014.
On the consumption side, the sustainable high prices have impact on consumers’ consumption
behavior which eventually feeds back into supply and demand to determine the prices of oil.
Business and individuals aim to conserve energy and also shift to alternative energy during rising
cost. Consumers stop using vehicles that are not so fuel efficient during high oil prices which
would therefore reduce their driving activity. These all, therefore, reduce demand.
Rising production towards the end of 2014 through 2016 and declining demands coupled with
significant decline in economic activities in China and Europe, resulted in oversupply which led
to a crash in prices to $40-50 per barrel. The downturn continued in 2016 until OPEC announced
the cut in production in Nov 2016.
Besides supply demand equilibrium, there are certain other factors which also influence prices
on oil. For e,g.
1. Geo-political risks in oil producing countries (ARAB Spring, political instability in the
Middle-East and Africa)
2. Investment funds flowing in oil as an asset class (artificially increases the demand)
3. Crude oil inventory maintained in strategic reserve
4. Idle refineries capacity and closure of refineries for maintenance
5. Long cold spell (weather) increase the demand of oil or shut down of factories due to
storms / hurricane reduces production.
Compliance by OPEC and Non OPEC members to adhere to supply cut is important determinant.
Over a period of time, prices generally tend to fall when supply is not meaningfully cut.
Ultimately, the strength of supply and demand will decide the equilibrium price.
Over the years, OPEC’s share has fallen due to new production coming from the United States
and Canada. This has led to new non-OPEC countries denting OPEC’s ability to significantly
influence oil prices and therefore, preventing sharp volatility in oil prices in the short run.