Alberto Behar & Robert A. Ritz
In 2014, global oil supply overtook demand and the oil price started to decline. In its November 2014 meeting, OPEC decided not to reduce supply and prices fell further. Oil-market analysts interpreted this as the formal decision to squeeze higher-cost US shale oil production out of the market. It also stood in contrast with OPEC’s coordinated cut during the Global Financial Crisis and Saudi Arabia’s role as a “swing producer” which seeks to accommodate changes in demand or production by other players. In its December 2015 meeting, OPEC reiterated its commitment to a “market-share” strategy. Many have opined on whether or not OPEC’s moves are sensible.
In a recent working paper, Alberto Behar, an economist at the International Monetary Fund’s Middle East and Central Asia Department, and former CEEPR Visiting Scholar Robert A. Ritz of the Energy Policy Research Group at the University of Cambridge, seek to understand the fundamental market factors that induced the shift in OPEC’s strategy. In their model, OPEC has a degree of market power and competes against a set of non-OPEC producers who act as price-takers. OPEC has a choice between two strategies. The first strategy, “accommodate”, is to maximize profits via a high oil price, which allows higher-cost non-OPEC producers to remain profitable. The second strategy, “squeeze”, is to drive up production and drive down price, thereby inducing high-cost producers, specifically US shale, to exit the market. The model shows that either of these two strategies can be optimal for OPEC depending on market demand and supply fundamentals.
The theory shows that the market-share strategy becomes relatively more attractive for OPEC given: (i) slower global oil demand; (ii) greater US shale oil production; (iii) reduced cohesiveness within OPEC; and (iv) higher output in other non-OPEC countries. A regime switch from accommodate to squeeze becomes optimal when US shale grows beyond a specific point. The model can rationalize OPEC’s decision to raise output in the face of weaker demand, and explain a large drop in the oil price. Unlike classic “limit pricing” in industrial-organization theory, the market-share strategy in the model does not rely on a later period with again-higher prices in which OPEC can recoup “lost” profits.
The empirical analysis shows how the model rationalizes the oil market in the period preceding the price collapse as a high-price accommodate scenario; OPEC optimally chose not to squeeze US shale despite having sufficient spare capacity to do so. Next, it shows how changes in market conditions can prompt a rational decision by OPEC to squeeze US shale out of the market. Finally, the model generates squeeze equilibria when calibrated to forecasts of future data that yield higher OPEC output and lower oil prices.
The model exposes the fallacy of interpreting a fall in OPEC’s revenues or profit as evidence that a market-strategy is necessarily misguided. The simple point is that the relevant comparison is not how profits compare to an earlier period, but rather how they would compare to pursuing a different strategy today—for which profits could be even lower.
It remains to be seen whether the initial logic of the squeeze will play out and vindicate the OPEC strategy. As of early 2016, the squeeze appears to have been less successful than OPEC might have calculated: a substantial decline in US shale output does not (yet) appear imminent, and the squeeze has perhaps been more costly than anticipated given the continued decline in oil prices. One potential reason is that the costs of US shale may have fallen more strongly than might have been anticipated. It is also possible that the attempted squeeze and the re-entry of Iran have reduced cohesiveness within OPEC so much that it reluctantly yet rationally persists with the squeeze.
The paper does not pretend to forecast the future of the industry but rather to provide a coherent economic framework to think about the key drivers of such regime switches, including the one that took place at the end of 2014.
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