Supply management in the oil market has entered a new era. The transition will force oil and gas companies to improve their handling of price risk.
Through most of its history, the oil market has employed some mechanism to align supply roughly with demand. Inevitably, the process is messy. Demand is unruly but fairly predictable-yet impossible to measure accurately in real time. Supply has complicated dynamics, with new production coming on line in variously sized increments while natural declines lower output rates from existing wells and fields. Management is possible, though, when some decision-making apparatus controls enough supply to influence price.
In fact, supply management seems to be necessary.
Governing supply
Usually, the market can provide more oil than it needs. Something therefore must govern supply at the frontier of market change. In theory, price should perform the function. In a perfect market, price would indicate demand change in real time, and supply would be adjusted with a giant valve. The real market-with its geographic diffusion, fragmented decision-making, cumbersome physical characteristics, long development cycles, and imperfect information-doesn't work that way. It has progressed beyond the chaos of Texan and Oklahoman oil fields of the 1930s, when unbridled production crushed crude prices and turned competition into anarchy. Without modulation, though, supply still can be erratic enough to aggravate price cycles, which in turn can hurt consumers, distort reservoir management, and create waste.
Since the Arab oil embargo of 1973-74, the governing mechanism has been the Organization of Petroleum Exporting Countries. Earlier, it was the Texas Railroad Commission in a role that evolved from a system of voluntary state prorationing with federal oversight, protected by import duties. Outside the US, supply management occurred through collusion of large oil companies and commitments to limit interregional competition such as the As-Is Agreement of 1928.
These arrangements swerved between legality and crime, often yielded to nefarious motives, worked clumsily for the most part, and infused the oil industry with political suspicion still powerful today. History nevertheless makes them appear to have been inevitable.
Last November, core OPEC members signaled their fading interest in supply management for defense of the value of crude oil. Saudi Oil Minister Ali al-Naimi has been outspoken about the reason. If OPEC succeeds in elevating the crude price by trimming production, higher-cost producers will just snatch market share and weaken the price anew. Especially with tight-oil resources, the supply response can be rapid. For supply management via coordination among producers, this is a new hazard.
OPEC hasn't totally abandoned coordination of supply. Al-Naimi lately has expressed willingness to reinstate the effort. Declines just starting in production from key tight-oil plays might nudge him and other OPEC officials in that direction.
But OPEC is entering a dicey era of its own. Tension between Sunni Saudi Arabia and Shia Iran is intense and getting more so. Iran craves a production increase and apparently believes an end to international sanctions soon will make that possible. Iraq aspires to production much higher than its recent 3.8 million b/d. Before Islamic State militants began their attacks, the Iraqi government said it wanted to reenter OPEC's quota system. Eventually, the exporters' group will have to make room for Iraqi oil. If between now and then Iraq drifts further toward sectarian alliance with Iran, OPEC's deliberations about supply restraint will be more contentious than ever.
New environment
The oil industry can't afford to assume market mechanics will resettle into their pattern of before last November, with OPEC estimating the world's need for its member crude and mainly obliging so long as price stayed within comfortable bounds. The market isn't that simple anymore.
To some as-yet unknown degree, the responsibility for production restraint is diffusing among supply points. In this new environment, individual producers must respond to price signs of incremental demand with incremental caution and become smarter than ever about when and-vitally-when not to supply oil.
