Two Miscalculations Force OPEC Reversal

SMITH BRAIN TRUST — A former energy industry executive at the University of Maryland’s Robert H. Smith School of Business says OPEC miscalculated two big factors when it voted to flood world markets with cheap oil in 2014, leading to Wednesday’s announcement of a course correction. “OPEC misread the situation in the United States and also in Russia,” Smith School professor Charles E. Olson says. "Now they finally have to curb production."

Led by Saudi Arabia, OPEC had hoped to fend off U.S. and Russian threats through continued high output — a strategy akin to chemotherapy. OPEC members would hurt themselves in the short term by bringing down profit margins, but competitors with higher production costs and lower cash reserves would suffer more in the long term.

Olson says the strategy broke down in the United States and Russia for different reasons, forcing OPEC’s concession at this week’s meeting in Vienna. “OPEC is running out of money, especially Saudi Arabia,” Olson says. “They’re spending down the hoard they had in U.S. Treasuries.”

U.S. Innovation

Trouble started in the United States with one flawed assumption. U.S. fracking costs more than Saudi drilling, so OPEC saw an opportunity to starve out the upstarts by driving down prices. “They thought these U.S. companies were in business because oil was $100 per barrel,” Olson says. “But they got that all wrong.”

What OPEC missed was the ability of U.S. frackers to adapt, bringing down theirs costs over time. “OPEC didn’t anticipate how efficient and innovative the U.S. frackers could be,” Olson says.

Russia’s Motive

Something different happened with the state-owned companies in Russia. OPEC executed a strategy to  squeeze Russian profits, but Olson says President Vladimir Putin cared more about other things.

“They were willing to sacrifice profits to be a disruptor in OPEC,” Olson says. “Russia wants attention, so they need to stir things up.”

Olson says Russia intervenes in Syria and Ukraine for similar reasons. “They’re no longer this powerful, prestigious nation that they once were, when they commanded respect,” he says. “So they’re going to be unpredictable.”

Something similar happens when commercial steel companies compete against state-owned mills in China and India. “It’s not about making a profit for these companies,” Olson says. “It’s usually about creating jobs and prestige. In the realm of emerging markets, you’re nobody if you don’t have an airline and you don’t have a steel mill.”

Olson makes another analogy closer to home. He says the University of Maryland maintains a fitness center to attract prospective students, while the YMCA has a social mission. Maximizing profit is secondary in both of these cases. “If you’re Bally Total Fitness, that’s tough competition,” Olson says.

Even without a profit motive, Olson says the OPEC strategy took a toll in Russia, which explains why Putin agreed to cut production by 300,000 barrels per day as part of the deal. “You can’t deficit finance forever,” Olson says.