OPEC at 60: The World With and Without OPEC

2018 started on a positive note for oil markets with Brent prices breaking through $70 a barrel for a few days and all the key international crude oil benchmarks flipping into backwardation. Yet, there is still a wide uncertainty engulfing the oil market, with very divergent views among market observers about how the oil price path could evolve in 2018, with some revising upwards their forecasts to higher than $80/b while others are less convinced that the market fundamentals can sustainably support a price above $70/b, expecting a lower path in the mid $60/b. The key uncertainties behind these divergent views mainly pertain to different views about: The OPEC/NOPEC exit strategy from the output cut agreement reached in November 2016; US shale supply response to the recent oil price rise; The potential impact of higher oil prices on global oil demand; The extent of supply disruptions amid a fragile geopolitical environment. In this Energy Insight, we analyse how the oil price path could evolve in 2018 by evaluating the aforementioned risks underlying the world oil market using a structural model of the oil market and considering various forecast scenarios. Forecast scenarios are not predictions of what will happen, but rather modelled projections of various oil price risks conditional on certain events that are known at the time of the forecast or some other hypothetical events. Our reference forecast scenario projects for Brent to trade within a narrow price range, with a price floor at above $60/b and a ceiling of below $75/b, with a 2018 average price of $67/b. The baseline forecast suggests that the momentum of stronger than expected oil demand and the OPEC/NOPEC output cuts have tightened the oil market in 2017 and even with no change in current market dynamics, the oil price will continue to be supported at around $65/b. Our results show that for 2018, US shale output growth will be the key factor putting a ceiling on the oil price, while supply disruptions could provide some support to the oil price, with a sharp fall in Venezuelan output constituting the biggest geopolitical risk that could push prices well above our baseline or reference forecasts. The results also show the paramount importance for the strong oil demand momentum experienced in 2017 to carry on into 2018 for rebalancing the market and supporting the oil price. Finally, our results show that for OPEC/NOPEC to maintain the recent price gains, they have to extend their output cut until the end of 2018; releasing the withheld barrels under the current agreement would result in a sharp fall in oil prices, suggesting that OPEC/NOPEC should be very wary about unwinding the output cut agreement when they next meet in June 2018. February 2018 Energy Insight: 28 Bassam Fattouh, Director OIES & Andreas Economou, Research Associate, OIES Oil Price Paths in 2018: The Interplay bertween OPEC, US Shale and Supply Interruptions

o Counterfactual analysis builds on a four-variable structural VAR model in the tradition of Kilian and Murphy (2014) 1 that decomposes the oil price to its components driven by flow supply, flow demand and speculative demand.
o Flow supply shock: shocks to crude oil supply that arise from geopolitical episodes, the output decisions of oil producers and other supply shocks.
o Flow demand shocks: shocks to the demand for immediate consumption associated with fluctuations in the global business cycle.
o Speculative demand shocks: shocks to stock demand reflecting the forward looking behaviour of the market participants.
o Other demand shocks: Other idiosyncratic shocks not captured by the preceding structural shocks.
o In constructing the counterfactual we replace the estimates of the flow supply shock ! " from 1992 to 2018 by counterfactual values reflecting the path of global oil production in the absence of OPEC spare capacity and follow Kilian (2016) 2 in providing explicit estimates of the impact on monthly Brent price.

Percent-changes in global oil production
Real economic activity index Real price of oil Level-changes in global oil stocks  (2014) to further decompose the supply components of the oil price to supply shocks that are explicitly associated with geopolitical disruptions (exogenous supply shocks) and those that arise from within the oil market by the output decisions of oil producers (endogenous supply shocks), along its demanddriven components.

Identification procedure
o This distinction is important because the impact of each distinct type of supply shock on oil prices differs greatly, both in terms of magnitude and duration.  o This framework enables the assessment of the joint evolution of the short-run price elasticities of oil supply and demand at each point in time.

Time-varying parameter VAR
Identification procedure o The GDP impacts are determined for two types of supply shocks in the CGE framework: o OPEC produces at maximum capacity in the absence of exogenous supply shocks.
o Exogenous production shortfalls elsewhere under full capacity utilisation in OPEC countries.
The welfare impacts are obtained by combining the actual and counterfactual oil prices obtained by the SVAR, as well as the actual and counterfactual production paths, with the annual GDP response curves obtained by the results of the CGE sensitivity analyses. 5

Crude oil production technology
The world with and without OPEC: An historical perspective Evolution of global oil production w/out OPEC Global oil production Global oil production volatility Source: OIES o In a world w/out OPEC, crude oil production would have averaged higher by 2.5 mb/d, with most of the difference attributed to KSA. The growth of global production however would have been slower by 1.5 mb/d .
o The volatility of global oil production would have averaged less than 0.8%, compared to the actual 1%, due to the absence of OPEC's output adjustments in response to oil supply and demand shocks hitting the market.

Price responsiveness to oil supply shocks
Price response to a supply disruption

Source: OIES
In the event of a hypothetical geopolitical supply disruption in oil supplies of 1 mb/d, the price response in the absence of spare capacity will be twice as large (actual case peaks at $6/b vs counterfactual case that peaks at $10.4/b).
But not only is the price increase expected to be larger, but also the price episode is expected to be longer in duration. That is because in the absence of spare capacity, the production shortfalls associated with some geopolitical episodes cannot be replaced by other producers, nor can stocks mitigate the impact of the supply shock on price until the latter have fully adjusted to the episode in question.
Essentially, in the absence of OPEC spare capacity the market has no mechanism to act as a buffer against abrupt oil disruptions, leaving it to prices to clear the market via large unexpected adjustments. o KSA would have experienced a slightly higher gain in market share relative to other OPEC oil producers by 2.6%, averaging 15% throughout, mainly due to its large low-cost oil reserve base.

Impact on World GDP
World GDP gains w/out spare capacity (% chg.) World GDP gains w/out spare capacity ($billion) Source: OIES o Shifts in OPEC output policy and abandoning its balancing role have global welfare implications that are channeled through the price outcomes. The impact however is different across regions and varies across time.
o A production increase leading to a 25% price decline would have boosted GDP by 0.15% in 2004/07 and 0.20% in 2011. The differences over time are higher when factoring in the global GDP expansion between 2004/11, leading to gains of $50B, $75B and $150B.