The West Continues To Cede Power To OPEC, Making Price Changes More Extreme

This previous weekend the Organization of Petroleum Exporting Countries (OPEC) announced further production cuts of a little over 1.1 million barrels per day from May onward. As can be expected, the U.S. was not too happy. The U.S. is in the middle of battling inflation and continues to raise interest rates to do so. These rate increases come at a cost, with recent casualties including Silicon Valley Bank. The prospect that a lot of the work on inflation could be negated as outside actors look to raise oil prices has them rightfully upset. The problem is that external actors will have more and more control over oil prices with the continued constraint of domestic supply.

Oil prices jumped over 5% on Monday after the announcement. How a 1% reduction in supply can create a fivefold increase in price is always surprising from the outside and shows the lucrative math behind cuts. The core cause is that price is set by the marginal barrel, referring to the additional barrel of oil that would need to be produced to meet demand beyond existing supply. It is the most expensive barrel to produce because it requires less efficient methods, which is why it wasn’t in market. If there is not enough supply to meet demand, the price of oil rises until the marginal barrel is sold out of storage or brought into production. Conversely, if demand falls, the price may drop until the marginal barrel is no longer profitable to produce. This is what we saw during COVID when prices dropped.

As OPEC controls more and more global supply, and the U.S. and other nations cede future market share, OPEC will have more control over price. There was a time in history when this was unthinkable but it’s politically easier to cede market share these days, given the focus on oil and gas emissions, until the ramifications of these decisions become clear with higher oil prices. Higher oil prices lead to increased inflation, and slower economic growth. Not to mention if you truly do view oil and gas development as incredibly risky you are ceding control of it to entities you have no influence over. More control is typically better if its important.

Biden ran on a platform that he would move the country away from fossil fuels. In 2022 he canceled the sale of drilling leases in the Gulf of Mexico and Alaska. This move was aligned with those campaign promises. The problem is that every project in the U.S. that is canceled or restricted means that long-term non-OPEC supply is removed from the future equation that impacts price. In contrast, Saudi Arabia currently has over 4 million barrels per day of approved projects that will give it more control over future supply, as other nations are comfortable with allowing their current supply to decline.

It will be interesting to see if the administration starts to balance a public narrative against new development with a practical approach that tries to maintain some security with domestic supply growth. The first sign of this may have been the approval by the Biden administration of the controversial Willow Project in Alaska. This is the largest proposed oil project on federal lands and is highlighted by environmentalists as the type of project that needs to be blocked. A few weeks ago though it received approval. It will be interesting to see if this is a trend, or if the US is comfortable ceding future oil price control to a collection of state actors.