IAEE Bergen June 20 2016 OPEC WHAT HAS

IAEE Bergen, June 20, 2016 OPEC: WHAT HAS CHANGED? James L. Smith Southern Methodist University, Dallas Texas jsmith@smu. edu

OPEC’s Impact: Price Level & Price Volatility

OPEC’s Impact: Price Level & Price Volatility

What Ails OPEC? “Today OPEC is at or near the limits of its power. It is in a market share trap. ”

What Ails OPEC? “Today OPEC is at or near the limits of its power. It is in a market share trap. ” “If they raise the price too high, they lose so much in sales that on balance they lose revenue. They can only find the optimal price or the monopoly ceiling by, again, trial and error. ”

What Ails OPEC? “Today OPEC is at or near the limits of its power. It is in a market share trap. ” “If they raise the price too high, they lose so much in sales that on balance they lose revenue. They can only find the optimal price or the monopoly ceiling by, again, trial and error. ” -- M. A. Adelman, 1992 “Deja Vu All Over Again, ” Energy Journal, vol. 36, Special Issue 1, 2015

SELL MORE OIL NOW. . . OR SAVE FOR FUTURE?

SELL MORE OIL NOW. . . OR SAVE FOR FUTURE?

A LESSON LEARNED TOO LATE? • If OPEC doesn’t expect oil to reach $1, 140/barrel in the next 35 years (and who does? ), they should produce more now. • To produce more now, OPEC must accept low prices—substantially below $100/barrel, and expand investment in new capacity. • OPEC’s job (like singing and mountain climbing) is much easier going up than coming down. (Professor Adelman) • Prudent long-term investors should not expect more than $60/barrel during the next decade.

A View of Long-Term Prices, circa 2005 J. L. Smith, “Oil Prices, OPEC Wealth, and Cartel Cohesion, ” CEEPR, MIT, April 21, 2005

Discord Within OPEC J. L. Smith, “Oil Prices, OPEC Wealth, and Cartel Cohesion, ” CEEPR, MIT, April 21, 2005

HOW DO HIGH OIL PRICES IMPACT OPEC? Short-Run Mostly favorable impacts, due to demand supply rigidities and long lead times. Long-Run Mostly negative impacts, due to demand supply reactions.

HOW DO HIGH OIL PRICES IMPACT OPEC? Short-Run Mostly favorable impacts, due to demand supply rigidities and long lead times. Long-Run Mostly negative impacts, due to demand supply reactions.

HOW DO HIGH OIL PRICES IMPACT OPEC? Short-Run p h ig . s e ric Mostly favorable impacts, h e d u l c n t i long lead times. due to demand supply rigiditiesnand o s e o d t I. d e v i r r a s Long-Run a h n u R g n Mostly negative impacts, o L The due to demand supply reactions.

HOW DO HIGH OIL PRICES IMPACT OPEC? OPE Cw Short-Run p h ig . s e ric ill st Mostly favorable impacts, h e ill de d u l fend c n t i long lead times. due to demand supply therigiditiesnand o pro s e i c d e. . . at t I. a low d e v i er le r r a v s el. Long-Run a h n u R g n Mostly negative impacts, o L The due to demand supply reactions.

Takeaways Regarding the Oil Price My conclusions have hardly changed since 2005: • The OPEC price represents a broad compromise among conflicting interests. The economic interests of OPEC members are not aligned. • Prior to October 2014, most of the burden of compromise fell on the Saudis, whose interest lies at the lower end of any price-band that OPEC might adopt. • Saudi tolerance of a high price-band is doubtful unless uncharacteristically strong cartel discipline is maintained going forward.

Takeaways Regarding the Oil Price My conclusions have hardly changed since 2005: • The OPEC price represents a broad compromise among conflicting interests. The economic interests of OPEC members are not aligned. • Prior to October 2014, most of the burden of compromise fell on the Saudis, whose interest lies at the lower end of any price-band that OPEC might adopt. • Saudi tolerance of a high price-band is doubtful unless uncharacteristically strong cartel discipline is maintained going forward.

Takeaways Regarding the Oil Price My conclusions have hardly changed since 2005: • The OPEC price represents a broad compromise among conflicting interests. The economic interests of OPEC members are not aligned. • Prior to October 2014, most of the burden of compromise fell on the Saudis, whose interest lies at the lower end of any price-band that OPEC might adopt. • Saudi tolerance of a high price-band is doubtful unless uncharacteristically strong cartel discipline is maintained going forward.

How Well has OPEC Defended Its Target Price? • OPEC’s mission statement: To ensure the stabilization of oil markets. • OPEC’s modus operandi: Tap spare production capacity to offset shocks to global oil demand supply. • Has OPEC indeed tamed volatility? (Answer: “yes”) OPEC’s Impact on Oil Price Volatility: The Role of Spare Capacity, by Axel Pierru, James Smith, and Tamim Zamrik, May 16, 2016.

How Well has OPEC Defended Its Target Price? • OPEC’s mission statement: To ensure the stabilization of oil markets. • OPEC’s modus operandi: Tap spare production capacity to offset shocks to global oil demand supply. • Has OPEC indeed tamed volatility? (Answer: “yes”) OPEC’s Impact on Oil Price Volatility: The Role of Spare Capacity, by Axel Pierru, James Smith, and Tamim Zamrik, May 16, 2016.

How Well has OPEC Defended Its Target Price? • OPEC’s mission statement: To ensure the stabilization of oil markets. • OPEC’s modus operandi: Tap spare production capacity to offset shocks to global oil demand supply. • Has OPEC indeed tamed volatility? (Answer: “yes”) OPEC’s Impact on Oil Price Volatility: The Role of Spare Capacity, by Axel Pierru, James Smith, and Tamim Zamrik, May 16, 2016.

What We Do • Fit a structural model to the behavior of OPEC spare production capacity, with:

What We Do • Fit a structural model to the behavior of OPEC spare production capacity, with: • An autoregressive stochastic process by which the residual demand for OPEC oil is shocked.

What We Do • Fit a structural model to the behavior of OPEC spare production capacity, with: • An autoregressive stochastic process by which the residual demand for OPEC oil is shocked. • A separate stochastic process by which OPEC attempts to estimate the size of shocks and offset them by regulating production from its buffer capacity.

What We Do • Fit a structural model to the behavior of OPEC spare production capacity, with: • An autoregressive stochastic process by which the residual demand for OPEC oil is shocked. • A separate stochastic process by which OPEC attempts to estimate the size of shocks and offset them by regulating production from its buffer capacity. • A loss function which describes the benefits that rationalize the investment in spare capacity.

Monthly Variation in OPEC Spare Capacity 7 Million barrels per day 6 5 4 3 2 1 0 сен- мар- сен- мар- сен- мар- сен- мар- сен 01 02 02 03 03 04 04 05 05 06 06 07 07 08 08 09 09 10 10 11 11 12 12 13 13 14 14 Spare capacity (source: IEA) OPEC Saudi Arabia OPEC Core

Comparison of inferred OPEC Core’s loss function to an independent estimate of global economic losses due to oil supply disruptions 900 - 800 Billion dollars 700 600 cs 500 on i om c d. E r 400 fo Ox 300 -3% -5% 200 100 0 0 0, 5 Spare 1 capacity 1, 5(source: 2 IEA) 2, 5 3 Size of a six-month outage, in million barrels per day § We use the Nov. 2014 reference scenario of Oxford Economics’ Global Economic Model, reduce the non. OPEC supply during the first two quarters of 2015, and compute the present value of world GDP losses

Conclusions • OPEC has not changed quite as much as some people would believe. • OPEC members with market power will continue to look to their own interest and continue to defend a target price. • Principal market power rests with the OPEC Core (Saudi Arabia, Kuwait, UAE, and Qatar). • The target price for the OPEC Core is undoubtedly much lower than $100/barrel. • Defense of a market price, at whatever level, entails stabilization of the market. • Spare capacity will continue to be used to offset shocks to global demand supply. • OPEC’s ability to recognize and offset shocks is imperfect, but not defunct. • Has the OPEC “regime” changed, or just been recalibrated?

Conclusions • OPEC has not changed quite as much as some people would believe. • OPEC members with market power will continue to look to their own interest and continue to defend a target price. • Principal market power rests with the OPEC Core (Saudi Arabia, Kuwait, UAE, and Qatar). • The target price for the OPEC Core is undoubtedly much lower than $100/barrel. • Defense of a market price, at whatever level, entails stabilization of the market. • Spare capacity will continue to be used to offset shocks to global demand supply. • OPEC’s ability to recognize and offset shocks is imperfect, but not defunct. • Has the OPEC “regime” changed, or just been recalibrated?

Conclusions • OPEC has not changed quite as much as some people would believe. • OPEC members with market power will continue to look to their own interest and continue to defend a target price. • Principal market power rests with the OPEC Core (Saudi Arabia, Kuwait, UAE, and Qatar). • The target price for the OPEC Core is undoubtedly much lower than $100/barrel. • Defense of a market price, at whatever level, entails stabilization of the market. • Spare capacity will continue to be used to offset shocks to global demand supply. • OPEC’s ability to recognize and offset shocks is imperfect, but not defunct. • Has the OPEC “regime” changed, or just been recalibrated?

Conclusions • OPEC has not changed quite as much as some people would believe. • OPEC members with market power will continue to look to their own interest and continue to defend a target price. • Principal market power rests with the OPEC Core (Saudi Arabia, Kuwait, UAE, and Qatar). • The target price for the OPEC Core is undoubtedly much lower than $100/barrel. • Defense of a market price, at whatever level, entails stabilization of the market. • Spare capacity will continue to be used to offset shocks to global demand supply. • OPEC’s ability to recognize and offset shocks is imperfect, but not defunct. • Has the OPEC “regime” changed, or just been recalibrated?

Thank You! James L. Smith jsmith@smu. edu