Why Reality Dictates A Price War
I would like to welcome you to the real world of the commercial oil business. Be careful, though, before you accept my invitation as it might result in a change in your thinking.
First, let us recognize that there are two oil worlds: the political one and the physical one. Both are real. Both are in play. I am not an expert on the political world. I am an expert on the physical world. And while either world can ignore the other world, at his own peril, it is prudent for a participant or analyst to consider both, to the maximum extent possible.
In the physical world, if the price of crude oil is maintained at a level of $75/B in today’s dollars, more production capacity can be created than the world will consume at that price level. That roughly describes the recent situation. How does the industry deal with the situation where everyone cannot produce at maximum capacity? Some capacity must be shut in. Who shuts in? The common answer presented by all non-OPEC producers and, yes, all OPEC producers, is “You cut”. Not “I will cut”. “You cut”. Therein lies the problem.
Historically Saudi Arabia was willing to respond to the “You cut” finger pointing at them. How nice of them. Now that they have joined the “You cut” group, everyone is mad at at the Saudis. Unfairly so, I would say.
What is the “fair” solution? The fair solution is for all the producers of the world to agree on a percentage for their production level. Worldwide pro-rationing! All producers would apply the same percentage to their productive capacity. Practical implementation is the problem of course. Who determines the percentage? Who guarantees that no one lies about their capacity? Who monitors each producer? Who applies the penalty for cheating? What price level is chosen for the industry to set supply needs? I think that it is obvious that the “fair” solution has no chance of implementation.
Now turning to the practical. What is a workable approximation of a fair approach? There is probably not enough honesty and integrity within the industry to ever achieve a “fair” working arrangement. Probably what will result in a commercially-driven accommodation that will be neither fair not stable. Instability and volatility are ahead of us, most likely.
What then of OPEC? When they controlled enough of the world’s production to be a major factor, rather than just one of many, they could have some clout. What they did not recognize at the time was that the international oil majors had been providing the function of stable prices at economically affordable levels. When the majors overdid the low price environment, they were thrown out by the OPEC countries. For a time Saudi Arabia tried to provide a price-stabilizing function, but, ultimately, they were beat down into the dog-eat-dog system that is now in place. The message to OPEC member countries is “Be careful what you wish for. The pigeons have come home to roost”. Now the Saudis are just one of a number of competitors who carry a big stick — maybe bigger than most. And OPEC as an organization remains a toothless tiger.
That is a summary of the physical world of oil. The guiding principle is “You cannot put ten gallons of oil in a five gallon bucket, no matter how much you wish for that result”. If Iran wishes to re-introduce the production that they lost to Saudi Arabia as a result of the sanctions, then Iran has to come up with a way to force the Saudis, or others, to shut in production so that they can produce their own oil in place of those who are forced to shut in. In the commercial world we call this a “Price War”. Look out!