OPEC, cost of production, and continued oil overproduction

The Saudi oil minister earlier in the year stated oil production will not be cut regardless of price. He is a man of his word. He argued that efficient oil producer should have a greater market share. This is more complex conversation about profit-maximizing behavior of depletible resources, but focus is on the fact that OPEC at this point in not going to let price determine its policy. The policy has been to eliminate marginal producers who are creating a oil glut versus global demand.

A look at oil production from the EIA show that the world is awash in oil. OPEC is pushing production to all-time highs although it has not broken through earlier production high. The non-OPEC world is where production is all of the excess production is still coming from. OPEC since the beginning of 2014 has raised production by just under 7% but non-OPEC production has increased by  just less than 12 percent. The overall production increase has been up 5.25 percent. If world growth is  less than this level, there will be excess supply. The current cost structure is such that production will continue and prices will fall because price is not yet equal to marginal cost for a lot of major producers.

If there is excess supply, there are three possible solutions. They are not independent but work in tandem to create a stable price equilibrium. First, prices fall. Second, there is the alternative to demand usage which is building inventories. This is constrained by the amount of storage that available. We have seen floating storage but there is a limit to where the market can put all of this oil. Third, there is a cut in production. Firms are cutting capital budgets. There has been a decline in rig counts, but what is really needed is a capping of well and less being pulled out of the ground. There has been some decline in shale oil production but not enough to have supply match current demand.

The market is is contango so it makes sense to hold back oil from the market. Money can be made by storing and hedging. The current price decline is consistent with what we are seeing with the high production.