Opec needs to read the Achnacarry Agreement of 1928
London — Oil cartel Opec members are struggling to protect their revenues in the face of renewed competition from US shale producers and other suppliers outside the organisation. Opec’s revenues from petroleum exports have fallen to just $446bn in 2016 from $1.2-trillion in 2012 (Annual Statistical Bulletin, Opec, 2017). But past experience strongly suggests Opec’s effort to stabilise oil inventories and prices while protecting its market share will fail.
Since the beginning of the modern petroleum industry, periods of high prices and concern about supplies running out have alternated with episodes of low prices and oversupply.
High prices and concerns about availability normally trigger an exploration boom and rapid innovations in drilling and production technology, as well as efforts to use oil more efficiently. The resulting increase in production and slowdown in consumption growth creates conditions for a subsequent slump.
The basic narrative has not changed since the first oil well was drilled in 1859, with periods of oversupply (1900s, 1930s, 1950s and 1990s) alternating with panics about shortages (1910s, 1970s, 2000s).
The current oversupply and slump in prices has its roots in the panic about peak oil and soaring prices in the middle of the last decade. High prices between 2004 and 2014 spurred an exploration boom around the world, as well as the widespread deployment of horizontal drilling and hydraulic fracturing techniques in the US.
At the same time, the cost of oil led to renewed interest among governments, businesses and consumers in greater oil efficiency and alternative energy technologies, including renewables and electric vehicles.
The slump which followed was inevitable as were the subsequent calls for more co-ordination among producers to cut output, reduce excess stocks and boost prices.
A shooting party
Every slump prompts calls for more co-ordination, restrictions on production, and the stabilisation of market shares (Crude volatility: the history and the future of boom-bust oil prices, McNally, 2017). The most notorious was the secret agreement reached between Standard Oil of New Jersey (forerunner of Exxon), Royal Dutch-Shell and the Anglo-Persian Oil Company (forerunner of BP) in September 1928.
Walter Teagle, president of Standard Oil; John Cadman, chairman of Anglo-Persian; and Henri Deterding, MD of Royal Dutch-Shell, met at Deterding’s rented castle in the Highlands of Scotland.
Afterwards, all Teagle would say was that "Sir John Cadman ... and myself were guests of Sir Henri Deterding and Lady Deterding at Achnacarry for the grouse shooting, and while the game was a primary object of the visit, the problem of the world’s petroleum industry naturally came in for a great deal of discussion." In fact the three men had reached a secret deal under which they would accept their current share of the oil market and not seek to increase it at the expense of the others.
A draft, which seems to have been adopted without alterations, is reproduced in the official history of BP (The History of the British Petroleum Company, Volume 2, Bamberg, 1994).
The Achnacarry Agreement, also called the "As-Is" agreement because it attempted to stabilise the status quo, is worth studying because of the close parallels with the current situation in the oil market.
Fears about shortages during the First World War and subsequent worries about the depletion of US oil fields in the post-war period had caused real oil prices to more than double from $15 a barrel in 1915 to $37 in 1920. The result was an exploration boom and a subsequent slump in prices, which had fallen to just $19 by 1923, and remained depressed through the rest of the decade, even before the onset of the Great Depression after 1929.
"Since its inception, the oil industry has looked forward with apprehension to the gradual depletion and final exhaustion of its supplies of crude oil," the preamble to the Achnacarry Agreement explained. "The temporary shortage of supplies that existed in certain countries during the Great War further accentuated this fear and caused vast sums of good money to be expended to locate and develop reserves in all parts of the world where petroleum potentialities appeared, as well as accumulating large reserve stocks above ground."
"Now the situation has changed. An adequate supply for a long time to come is assured. This is the result of the application of science to the petroleum industry. On the other hand, more effective methods of handling crude have been developed so that the yield of gasoline from a given amount of crude has been enormously increased."
"Methods of consumption are being made more economical; high compression motors are being developed; diesel engines and fuel oil is being is being utilised more efficiently and economically. All these developments will have a marked tendency to slow down the rate of increase in consumption," the agreement warned.
"Excessive competition" had resulted in tremendous over-production, as each oil company "has tried to take care of its own over-production and tried to increase its sales at the expense of someone else". The result was "destructive rather than constructive competition". No company could hope to cure its over-production by increasing its market share when all the others were attempting to do the same.
The rational solution was a market-sharing agreement in which all three companies agreed to accept their share of the current market and a proportionate share of any future growth in oil demand.
As-Is specifically excluded oil production and imports into the US because any attempt to cartelise the US market was prohibited by US anti-trust law.
Standard Oil nonetheless organised the Standard Oil Export Corporation and the US Export Petroleum Association in a bid to control US exports of crude and refined fuels to the rest of the world. And the three companies sought to formulate guidelines for competition in other countries with the Memorandum for European Markets signed in 1930 and the Heads of Agreement for Distribution signed in 1932.
Ultimately, however, the Achnacarry Agreement was a failure.
Part of the reason was the Great Depression, which resulted in a slump in oil demand, just as the oil companies were trying to restrict supply. But the discovery of the super-giant East Texas field in 1930 sparked an uncontrolled drilling race and a flood of oil onto US domestic markets and into exports.
The Achnacarry companies also proved unable to stem the flow of cheap crude from Russian and Romanian producers, both outside the agreement, into European markets, where it captured their market share.
Achnacarry holds many lessons for Opec.
The shale boom and growth of non-Opec supplies are a reaction to earlier fears about shortages and high prices, just as the exploration boom of the 1920s was a response to earlier fears about field depletion.
Opec’s ability to co-ordinate with US oil producers is constrained by US anti-trust laws, similar to the loophole in the Achnacarry Agreement, but without their collaboration it will prove hard to stabilise market shares. And any effort to stabilise market shares and support prices risks being undermined by new supplies not covered by the agreement.
Opec faced a similar problem 50 years later when the sharp rise in real oil prices as a result of the two oil shocks in the 1970s led to a surge in supplies from non-Opec producers. Increased output from the North Sea, Alaska, the Soviet Union and China cut Opec’s share of the global oil market from 51% in 1973 to 28% in 1985.
Opec never really managed to reverse the loss of its market share. Production from "high-cost" sources such as the North Sea and Alaska proved surprisingly resilient, despite lower real oil prices in the 1980s and 1990s.
Only the collapse in output from the former Soviet Union during the 1990s and the rapid growth of the East Asian Tiger economies in the 1990s and China’s industrialisation in 2000s restored the organisation’s fortunes.
Efforts to stabilise the oil market have always failed because they cannot control the emergence of alternative supplies from rival suppliers and the reaction of consumers.
Opec is no more likely to succeed in containing the challenge from shale today than it was in dealing with the earlier challenge from the North Sea or the Achnacarry companies were in dealing with East Texas.
• Kemp is a Reuters market analyst. The views expressed are his own.