What do cartels and OPEC have in common?

Cartel behaviour in business in order to increase the price of a particular good is illegal in most countries. For example, a raft of banks have recently been fined large sums of money for deliberately manipulating interest rate benchmarks such as LIBOR. Interestingly, the oil market is perhaps the only market in which such behaviour is not only not illegal, but rather it is almost encouraged. OPEC is the Organisation of Petroleum Exporting Countries formed in 1960 and its role is to align the interests of the member countries who collectively make up over 30% of the world's oil production. Historically, OPEC members have acted in unison to restrict oil output when prices are low. For example, in the 1980's a group production ceiling was introduced in response to low oil prices.

There are several large ASX listed petroleum producers including Woodside Petroleum (WPL), Santos (STO) and Oil Search (OSH) whose profitability depends heavily on oil and gas prices. These companies are therefore beneficiaries of any OPEC behaviour that seeks to restrict output. Unfortunately for the shareholders of these companies, oil prices plunged in late 2014 to lows of below $30 per barrel after trading above $100 per barrel in prior years. Broadly speaking, the reason was an oversupply of oil but there were several specific contributing factors. Firstly, the high oil prices in prior years had spurned a large shale oil industry in the United States. Shale oil output from the US surged between 2011 and 2015, increasing by approximately 70% over this time. Secondly, sanctions on Iran were lifted after a deal was reached regarding the country's nuclear development plans allowing Iran to resume oil exports. As a result, Iranian production has been ramping up considerably. Finally, several other war torn countries, such as Iraq and Libya, have been increasing production as their countries recover from the effects of extended periods of conflict. In combination, these effects caused a significant oil oversupply and have pushed oil in storage to record levels.

Source: Rivkin, Reuters

OPEC has been very slow to respond to the weaker prices. One major concern for OPEC is that any deal to cut production would simply see them lose market share to the non-OPEC oil producers such as Russia and US shale companies. As US companies are not state owned, no single entity can control how much oil they produce, in contrast to OPEC members whose oil industries are state owned and/or controlled. Furthermore, Russia production had been ramping up to post-Soviet highs and OPEC feared that any cut they made would be quickly supplanted by increased Russian production. Nevertheless, OPEC managed to organise a meeting last month at which coordinated cuts were to be the order of business.

To the surprise of many in the industry, OPEC actually came out of the meeting with agreed production cuts including quotas for each of the member countries. In addition, Russia had agreed to also cut production. This deal came after at least two years of indecision from OPEC regarding its response to the weak oil prices. The effect of the announcement on oil prices has so far been positive but perhaps not as much as producers had hoped. A barrel of WTI is currently trading for just over $50, near recent highs but still well short the $100 per barrel from early 2014.

Oil producers such as WPL and STO have struggled during this period of low prices. Although they have managed to reduce production costs somewhat, oil prices are still very close to the limit of profitability for these companies. STO estimates that it break-even oil price is US$39 per barrel which is down from US$47 at the start of 2016. It has also recently announced a plan to sell some of its non-core assets to raise cash to pay off some of its debt which is hoped will reduce net debt by around a third by 2019. Shareholders will be hoping that OPEC production cuts work quickly to restore prices to more profitable levels and markets will be watching to see whether OPEC members actually stick to their agreement.

This article was written by William O'Loughlin – Local Investment Analyst, Rivkin Securities Pty Ltd. Enquiries can be made via william.oloughlin@rivkin.com.au or by phoning +612 8302 3600.