Bob McNally, one of the smartest obsevers of the nexus of energy and politics around, published a provocative note last Thursday on the recent evolution of OPEC and what it means for global oil markets. In light of what’s been going on in the Middle East, I thought it would be worth excerpting at some length. Here’s how he starts:
We believe the 36-year era of OPEC oil price control ended in 2008, giving way to a new, indefinite "Swing Era" in which large price swings rather than cartel production changes will balance global oil supply and demand. The Swing Era portends much higher oil price volatility, investment uncertainty in conventional and alternative energy and transportation technologies, and lower consensus estimates of global GDP growth. Ironically, Western governments and investors will miss OPEC, or at least the relative price stability it tried to provide
After talking a bit about history since the early 1970s, he turns to the last price shock:
From 2005-2008, it was OPEC’s turn to fail to rise to the task when needed. It was the first instance during peacetime when OPEC spare capacity was depleted…. In 2008, market balance was only achieved through a brutal price spike that rationed demand and crushed income.
What does that mean for the future?
Looking to the foreseeable future, a replay of super-tight 2005-2008 fundamentals is not a question of if, but when…. Saudi Arabia holds the bulk of spare capacity, but has frequently stated it wishes to keep only 1.5-2.0 mb/d. Even if total oil production is far from a peak, ex-ante demand growth is likely to outstrip net supply growth, draining spare capacity and requiring demand-rationing, if not GDP limiting, price increases to ensure consumption and supply growth are balanced.
Bob doesn’t think that OPEC is completely done, but he does think that its influence will be significantly lessened:
In the future, OPEC can maintain a price floor by cutting supply. But insufficient spare capacity will deprive it of the power to impose a ceiling. When demand growth again whittles spare capacity below 2 mb/d, prices will soar….
I’m pretty sympathetic to this argument. I also think that it has big consequences for how we need to think about oil. But I’d still throw in a few notes of caution. First, if global economic growth falls substantially below expectations, Saudi Arabia might find itself with considerably more spare capacity than planned. That scenario could leave it with real stabilizing power for much longer. Second, the current unrest in the Middle East might make Riyadh rethink its attitude toward holding spare capacity: if high fuel costs drive unrest, and that unrest has the potential to spread to Saudi Arabia, it could get policymakers’ attention. Third, while more volatile oil prices would be a net negative for the U.S. economy, part of the impact might be lessened by the deepening and broadening of hedging products. Right now, it’s tough to hedge oil exposure out more than a year or two, in part because would-be market makers are uneasy with the political risk that stems from OPEC’s role in the market. If the oil market starts to look more like, well, a market, consumers might be able to hedge more effectively, which would help blunt the impact of increased volatility a bit.