Why OPEC May Have a Long, Costly Battle on Its Hands

By Markets Fool.com

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An offshore drilling platform owned by Seadrill. Source: Seadrill.

If OPEC is indeed keeping oil production high in an effort to squeeze out U.S. shale producers, they may have a long, long wait for their strategy to play out. Oil prices fell this week because, despite low oil prices, U.S. producers keep pumping more and more oil.

As a result, inventories are on the rise, and there appears to be no end in sight to the glut in oil production. For OPEC, this could be a long and costly battle.

The big problem in oil today
What's driven oil prices lower in the last six months is a simple imbalance of supply and demand. The world -- and the U.S. in particular -- is producing more oil than it consumes, and eventually, that leads to falling prices. In the oil industry, it can be difficult to see oversupply coming, but when everyone realizes it's here, prices can fall rapidly.

The problem in oil today is that oversupply isn't going to stop any time soon. In fact, the problem is getting worse, even with oil trading around $50 per barrel. Below is a chart of U.S. commercial crude oil stocks since the beginning of June, when the price of oil started to fall. You can see that not only are producers not reacting by cutting production, they're producing far more oil than we consume, and the problem is getting worse.

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Source: U.S. Energy Information Administration; chart by author.

Part of the problem is the lag between when an oil well is drilled and when it becomes uneconomical to keep operating it. For example, an oil company may have an all-in cost of $70 per barrel for oil from new wells, so it may determine that drilling a new well today isn't economical and won't drill it. We're seeing those decisions in the form of major cutbacks in capital spending plans across the industry.

But if you drilled a well in, let's say, June of last year, it may only cost $10 per barrel to keep producing oil and fracking that well over and over again over the next few years. So, as an oil producer, you're not going to stop producing oil just because oil is as $50 per barrel, you're just going to stop drilling new wells.

Source: LINN Energy.

The challenge is that this can still lead to year-over-year growth in oil production, making oversupply worse. The U.S. Energy Information Administration predicts that crude oil production in the U.S. will grow from 8.6 million barrels per day in 2014 to 9.3 million barrels per day this year, and 9.5 million in 2016. Crude oil prices are falling, but supply is rising, which is almost a paradox of supply and demand.

OPEC's rock and hard place
This dynamic makes for tough decisions in countries that rely on oil for a majority of their revenue. As the theory goes, OPEC appears to be trying to squeeze U.S. shale producers out of the market, but to do so, it may need to keep the market oversupplied for multiple years. The problem for OPEC is that it has insanely high stakes.

The EIA predicts that OPEC countries are losing out on $375 billion in revenue this year just because of low oil prices. The challenge is, it could simply agree to cut production by 2 million barrels per day, and prices would jump, potentially to $100 per barrel again, but it would be giving up market share to do so. Short term, this would absolutely be the right move, but long term, OPEC would be giving up market share and control of the oil market.

So, what do you do if you're OPEC? If it's going to take 3-5 years to squeeze shale producers enough that they begin cutting production, and in the meantime you're giving up hundreds of billions of dollars in lost revenue, is it worth it? Is it even guaranteed that $50 per barrel will cause shale production to tale off long term?

The paradox of oil markets
Given the rise in crude oil inventories to record levels, despite low oil prices, it's easy to see how oil prices could stay low for the next few years as producers keep pumping out more oil than the world needs.

For OPEC, that's a long time to wait to see results of squeezing marginal oil producers. Is the risk worth the reward at the end of the day? Only time will tell.

The article Why OPEC May Have a Long, Costly Battle on Its Hands originally appeared on Fool.com.

Travis Hoium owns shares of Seadrill. The Motley Fool recommends Seadrill. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.