Sunday, November 13, 2016

Chart of the Day: OPEC Price, Output, and Revenue

While doing some research for my book earlier this month, I came across an interesting graphic created by Dermot Gately in his paper "Lessons from the 1986 Oil Price Collapse." The chart provided a useful perspective on the equilibrium price of a barrel of oil during a period where OPEC sought to control the price by cutting production after it fell to lows in the 1970's. Revenue levels for the oil cartel declined to almost $50 billion endangering the health of many economies that relied on its natural resources for survival.  As more members began to feel the pain of tighter trade balances, more support for a supply cut forced the hand of the swing producer, Saudi Arabia. The price control worked until 1986 when prices crashed again.

From Gately's "Lessons from the 1986 Oil Price Collapse"

Gately's chart plots output, price, and revenue on a graphical space that can be pictured as a curve in three-dimensional space, but, for informational purposes, it relies on level curves to make its point. The display is also set up to reflect the structure of a standard supply and demand graph with price on the y-axis and output on the x-axis, and this allows us to theorize about an equilibrium if the data provides some structure to the behavior of the market. Because OPEC acts as a cartel with quasi-monopolistic powers, plotting its output alone is sufficient. 

At first glance, I noticed that the behavior of the OPEC output movement appeared cyclical from 1970 to 1986. With the exception of a kink in the late 1970's, the trend in the market appears to mirror a positive feedback loop in which price and OPEC output respond to each other's movement with revenue level accelerating the shifts. As prices grew from 1973 to 1974, OPEC kept output levels high to take advantage of higher revenue. In 1980, prices peaked after the global supply of oil had grown from the growth of production in North America and OPEC. In response, the cartel attempted to cut production to cushion the fall to a low in 1986. Prices would bottom out later that decade and, encouraged by low revenue levels, OPEC would add to output in anticipation of a higher equilibrium price. Saudi Arabia's data reflects the same kind of trend but with more inelastic output changes. From 1970-1973 and 1980-1985, the Middle Eastern nation had the most flexibility in its output policy. The years following the shifts in production were defined by dramatic moves in price suggesting that OPEC's swing producer had an enormous amount of control over the pricing mechanism. Although, is was still susceptible to the cyclical trend because its government relied on oil revenues to keep the country operating.

But 1986 is history, and if one reads more and more about the behavior of 20th century OPEC, it becomes quite predictable amidst the countless number of regional conflicts and price control tactics. Using the behavior in this period as a predictor of what should or could happen in the most recent oil glut of 2014-2015 has proven to be useless. This is most likely caused by the growth of non-OPEC supply, particularly the North American shale producers. Nevertheless, OPEC actions still have some effects on the markets, but, overall, the effects are muted. To investigate the fundamental picture, I recreated the chart above to track the movement of price and output in relation to revenue from 2000-2015 using Gately's style.

Based on price data from OPEC's Statistical Review adjusted for inflation and exchange rates and daily output figures from the Monthly Oil Market Reports, I was able to map the two series over some revenue isoquants calculated by multiplying price and output together. The behavior that is observed between 2000-2016 is very different from that of 1970-1986 with a circular figure turning into a curve that appears to trend linearly over time (as shown by the purple trendline). We have a gradual increase in OPEC output accompanied by a quasi-proportional increase in the price of oil up until 2008. The financial crisis occurs producing a slight deviation from the trend which reaches its peak, in both price and output, in 2012. Based on a linear regression analysis, we can develop a theoretical supply function that appears to define OPEC price policy from 2000-2012. So have we observed a deviation from the monopolistic behavior we saw in the previous graph? Not exactly.

The oil cartel is taking advantage of the inelastic qualities of petroleum demand to secure the best price for each barrel they produce. Because OPEC member nations need to reach these higher revenue levels to support the growing costs of government and higher rates of inflation in the 2000's, they seek to optimize policy to be as far right on the supply function as possible. In order to do this, OPEC made use of the regional conflict in Iraq and demand growth in emerging economies to achieve its goal, but there would be residual consequences. Remember how higher revenue levels would accelerate the trend in the opposite direction as producers seek to maximize output to reach even higher revenue levels? Well, the trend of price leading up to 2012 sparked a new set of producers to optimize and, in the end, flourish. North American shale producers reaching untapped reserves and pumping them quickly challenged OPEC for its market share causing the green line to drop to where the awkward looking 2015 data point falls. Here, the market has changed as OPEC's monopolistic powers are threatened by this surging source of output. This new competition can be modeled by a shifting of the purple supply curve so that to intersects the 2015 data point. The oil cartel now has less control over its revenue streams.

The new pricing mechanism in the current market will not allow a trend like that of the early 2000's to develop. For that reason, OPEC has been wary in trying to influence the market with an output freeze (or an outright cut). While that cut in the 1970's would have supported price, one in 2016 would be met by an increase in North American shale output. Saudi Arabia hinted at this shift in power when it announced a sale of 5 percent of Aramco stake in the U.S. markets with the goal of financing an investment fund that would reduce the country's reliance on fossil fuel income in the long run. Suddenly, OPEC looks useless despite calls for action by investors have suggested otherwise. At the moment, only a Saudi Arabian-Russian agreement looks to have any major effect on the price of oil, but based on economic circumstances in both countries, neither can risk a drop in output being negated by an increase in North American production. In the end, I see OPEC countries being forced to come to terms with a new oil market. After all, renewable energy is getting cheap, and there is clearly a global preference for those energy sources.  

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