June 29, 2017


OPEC, Oil Prices and Disruptive Innovation : Cost-cutting advances in shale are weakening the cartel's grasp of energy market dynamics (Mohamed A. El-Erian, 6/29/17, Bloomberg)

Until this quarter, the revised approach was largely successful in stabilizing prices in a range that both producers and consumers could live with. But, below the surface, its durability was slowly being eroded by three factors: signs that exempt OPEC producers may move the production needle more than initially expected; indications of non-adherence to the ceilings by non-OPEC producers; and, most importantly, by the increasing ability of non-traditional suppliers to operate at lower prices given both ample market financing and cost-cutting innovation.

This third factor puts OPEC in a particularly tricky situation, as illustrated by the literature on disruptive innovation. Pioneered by Harvard Business School's Clayton Christensen, it shows how technological advances can empower new entrants to take market share from established providers, and to do so at declining prices. New value chains are created, either in a new parallel market or, as illustrated by what Southwest Airlines did to the major airlines in the U.S. a few decades ago, in an existing market.

In the case of shale, the disruptive innovations started out with high unit production costs. As such, the producers were initially just an irritant to established suppliers, including OPEC. But, with time, rapid evolution and adaptation allowed them to capture a growing market share, while also redefining the pricing dynamics for the industry as a whole. If this disruption process proceeds further, it will force established suppliers to seek more fundamental adaptations or risk a greater secular decline that is increasingly hard to reverse.

At first, the non-traditional energy supplies were expensive, small and relatively localized. But their impact has been changing, especially when powered by cost-cutting innovations, allowing them to climb the value-added chain. Most recently, they have surprised many by being able to increase output at the new $45 to $55 per barrel price that OPEC helped establish and maintain.

Unlike companies facing such disruption (again think established firms versus new entrants), OPEC members have fewer cost-cutting strategies available to them. They can't merge and consolidate as some disrupted companies have been forced to, and their existing cost structures are relatively entrenched. Their main strategic alternatives boil down to either going all out to undermine the disruptor -- implying oil prices probably around $20 to $30 for a while -- or they manage a gradual secular reduction in revenues due to eroding market share that proves very hard to regain.

In terms of the market, these dynamics suggest the establishment of a series of price ranges around a declining trend. 

Posted by at June 29, 2017 5:48 PM