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Saudi Arabia gambles as Opec makes no cuts

The kingdom’s shift in strategy is as risky as it was abrupt

Youcef Yousfi, Algeria’s oil minister, was adamant when he spoke to Petroleum Economist on the morning of Opec’s 27 November meeting. His country would “of course” trim its own output as part of a wider group cut, he said. He dismissed rumours that the Gulf states had already agreed to hold output steady. Cuts were coming, he suggested, and they would restore prices to “where they were before”.

Rafael Ramirez, Venezuela’s foreign minister and Opec representative, was also convinced. Before the meeting began, he told a huddle of journalists gathered around him that Opec should go deep, stripping the market of supply in the way it had done in Oran, Algeria, in 2008, when the group agreed to cut output by 2.46 million barrels a day (b/d). That move six years ago dragged oil prices off the floor.

Instead, as the meeting got under way, Saudi oil minister Ali al-Naimi, laid down the law. During the six-hour meeting he told the ministers around Opec’s horseshoe table that there would be no cuts. The group needed to face the threat from rising non-Opec supply, especially tight oil, whose surge in the US has sharply reduced Opec’s presence there. The fix for low prices was low prices. Let higher-cost tight oil wither. The market would heal itself.

Falling prices

Within minutes of that decision reaching the market, prices plunged. Yousfi, before he faced journalists, told colleagues that Saudi Arabia had made a “revolutionary decision”. Ramirez stormed out of the group’s headquarters on Helferstorferstrasse, his face a picture of unconcealed rage.

Their anger was understandable – and so was their surprise. Saudi Arabia had made efforts in the weeks leading up to the meeting to find a consensus to cut. Now the kingdom had dramatically changed tack, abandoning any defence of $100-a-barrel oil – the level Naimi had many times called a “fair price” for producers and consumers. Its willingness to let the market drift is also a colossal risk. No one can be sure how far prices will have to fall to stunt the rise of tight oil, or whether the strategy will even work. But everyone knows that as the market sinks the economies Venezuela, Algeria, Iran, and Iraq will suffer. Saudi Arabia, believed some within Opec, was gambling with the fortunes of its fellow members.

Under those circumstances, group unity is also now under threat. The splits are now plain. Backed by other dovish Gulf members, Saudi Arabia’s stance was a resounding assertion of the kingdom’s authority – and its ability to bend Opec to its will.

This was reflected in the communique that followed the meeting. It acknowledged that the world was “extremely well-supplied”, but in almost the same breath said that Opec would do nothing to correct this. The statement abandoned the usual language calling on members to “adhere” to the 30m b/d target, which has been consistently exceeded since its introduction in 2011, and made no mention of the group being ready to meet again earlier than June.

Beyond abolishing the target altogether, Opec could hardly have offered a more bearish signal to the market. “There is not a single thing for bulls to latch onto,” one analyst said of the communique. “It’s a free-for-all,” said another seasoned Opec-watcher. A price war was now under way, others said. Opec hardly denied it. The decision not to cut output, said Abdalla El-Badri, the group’s secretary general, was Opec’s “answer” to rising tight oil supply.

Not everyone accepted the line that Saudi Arabia’s about-turn was directed at North America. The most benign argument to let the market fall was that a spell of lower oil prices would help revive the global economy and boost oil demand growth, which has been tepid. Others said simply that cuts either wouldn’t work or, if they did, would simply pass more of the market into rivals’ hands while rewarding them with better netbacks.

The aftermath

As ever with Opec, though, in the meeting’s aftermath internal rivalries also came to the fore. Iranian officials saw the Saudi decision as a direct attempt by a geopolitical rival to hurt their country’s economy. “It was a political decision,” said a source in Iran’s Opec delegation on 28 November. The kingdom was deliberately trying to punish Iran, Russia and Venezuela for their support of Syria’s Bashar al-Assad, he said. All three countries’ economies are now vulnerable to a slump in crude prices.

The abruptness of the kingdom’s shift in policy added to doubts that tight oil was the sole focus of the new strategy. In the weeks running up to the meeting in Vienna, the kingdom was still trying to garner support for cuts, say people familiar with the Saudi oil policy. Taking that cue, half of the Wall Street analysts polled by Bloomberg before the meeting expected the kingdom to lead a round of cuts to curb the supply excesses in the market.

Crucially, Saudi Arabia was insisting that non-Opec nations take part, fearing that without wider participation the cuts would not shake the market from its stupor.

In a meeting on Margarita Island in Venezuela in mid-November, Naimi told Ramirez that if Venezuela could secure cuts from Russia and Mexico the kingdom would agree to a wider Opec market move. (Norway was not part of the plan.)

For Ramirez, it was a tricky task, possibly doomed from the start. Mexico was an unlikely collaborator, given plans to open its upstream to foreign investors. Russia’s relations with Opec have often been difficult. Ramirez, knowing how important an oil price revival would be to Venezuela’s economy, nevertheless set off on his errand. The outcome was the meeting on 25 November in Vienna, two days before the Opec conference, between Naimi, Ramirez, Russian energy minister Alexander Novak, Rosneft boss Igor Sechin, and Mexico’s oil minister Pedro Joaquin Caldwell.

At that point, Saudi Arabia was still willing to consider cuts to defend the price. The discussions went badly. Sechin, a key ally of Vladimir Putin, said that Russia would agree to cut. Energy minister Novak promptly overruled him, according to people familiar with the meeting, saying Russia would play no part. Saudi Arabia was left baffled by the response, wondering why the two Russians had even turned turn up in Vienna. The chances for a cut ended with that meeting. This was confirmed a day later, when a senior Saudi oil ministry official briefed a hand-picked group of trusted analysts at a dinner he holds before each Opec meeting.

Saudi Arabia was now ready to “take its hands off the tiller” for a while, the official told the group. Several analysts told him the market would dump oil as soon as this news reached it. The official was unmoved, saying that the decision not to cut would probably send oil prices a few dollars lower, but not for long.

The next day, while US markets remained closed for Thanksgiving, oil prices lost almost 10% of their value within an hour of Opec’s announcement, with WTI ending the day below $70/b and Brent just above $72/b. On 28 November, a limited recovery was swiftly snuffed out and two benchmarks fell again, to around $66/b and $70/b, respectively.

Many market commentators now expect further softening, especially as the glut of oil grows in the coming months. Opec says it won’t meet again until June, by which time the fundamentals could look ugly for the group. Seth Kleinman, an analyst at Citi, says the excess supply could rise from around 700,000 b/d now to 1.3m b/d in the first half of 2015.

If Opec’s strategy really is to beat back tight oil, it should have a better idea by then of unconventional oil’s resilience to weaker prices. But analysts are sceptical. Tight oil is about “hundreds of people at dozens of companies making thousands of decisions”, said Jamie Webster, senior director of global oil markets at IHS. No one could say what price would stop the sector’s growth, he added.

Market signals

Others pointed out that to keep tight oil at bay prices would have to drop below the break-even point - and stay there. Shale drilling could respond quickly to market signals as the price dropped, and wells could be shut in. But any reversion to higher prices would simply bring supply back on line just as fast. And fathoming the crunch price for tight oil could also involve a lot of pain for Opec members. The economies of Venezuela, Iran and Iraq are already creaking. Further price drops would imperil them. Even the group’s Gulf members would have to adjust spending plans. The collateral damage will bring a renewed clamour within the group for even deeper cuts.

The Gulf countries that refused to cut may want the market – by which they mean higher-cost tight oil suppliers – to restore balance. But they will need nerves of steel as they wait for the shake-out to happen. If the oversupply lingers too long, the calls for Opec to reclaim its price-setting position in world oil will become irresistible. If Saudi Arabia is determined to follow its strategy to the end, 2015 won’t just test tight oil – it will also the kingdom’s resolve to stay out of the fray.

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