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End of the war for Opec

In the end, the fiscal pressures and income loss were too great for Opec’s members to bear—and the rewards of the market-share strategy too meagre

In January 2015, Oman's urbane oil minister could barely hide his contempt. Just two months earlier, at Opec's fateful November 2014 meeting, the group-of which Oman is not a member-had stared at a weakening oil market and decided to do nothing. In the memorable words of one Saudi oil adviser, the kingdom had decided to "take its hand off the tiller".

But Mohammed al-Rumhy was having none of it. "I really fail to understand how market share became more important than revenue," he said from the podium of a Petroleum Economist conference in Kuwait City. "We have created volatility-and volatility is one of those words that's bad for business." It was "politics that I don't understand". Lots of the industry's other collateral victims of Opec's decision liked the tone of his comments.

Now the end of Opec's war for more customers is nigh. Even if the group fails-as it often does-to deliver on its new pledge to cut, the experiment with free-market liberalism is over. Naimism, the Saudi policy to force "inefficient" producers out of business, has been a costly blunder that Opec might never recover from. Its members will descend from the ring with deep bruising-and much poorer.

No one should shy away from saying it: Opec lost its battle. It recovered a bit of market share-its slice of global supply was 34.06% in September, compared with 31.97% in November 2014. But, in exchange for a crash in its oil income and deepening fiscal problems in some of its members' economies, the extra two percentage points hardly seems justified.

What, really, was the strategy?

If American tight oil was the target, the victory was pyrrhic. Yes, hundreds of rigs have been idled in the past two years and US shale output has fallen. But a leaner, meaner machine has emerged in the ashes, able to produce more oil from fewer wells while spending. Wall Street stands by, ever eager to finance it all again.

Winless streak

If costly deep-water production or the oil sands and other big-ticket projects were in Opec's sights, the outcome would have been just as bad. The collapse in global upstream spending means one of two things, neither of them helpful to Opec. The hiatus in investment decisions now will force prices sharply higher when today's glut burns off over the next few years-that's one possible consequence. Yet it is in no producer's interest to see another price spike. Electric and hybrid vehicles, gasification of transport, relentless tightening of climate-change rules and government efforts to curb fossil-fuel use are now embedded trends: the legacy of the last bonanza. And these changes march on at $50-a-barrel oil. The demand-side response at $75 or $100 could be terminal.

Saudi Arabia's new oil minister, Khalid al-Falih, entrusted with managing Saudi Arabia's return to market management, seems fearful enough of this scenario. At the Oil & Money conference in London in October he talked of "alarm bells" sounding about a "future supply shortfall" if investment wasn't forthcoming. Saudi Arabia doesn't want another damaging surge. The kingdom has implicitly accepted the risks now facing producer economies. Its 2030 Vision, announced earlier this year, is fundamentally a ploy to wean the country off oil dependency before it is too late.

But the alternative outcome of this dearth of new global projects is just as bad for the industry. Maybe the world will find out now that it no longer needs as many costly big offshore projects as people thought. That, as prices creep up, investment pours back into tight oil and other fast-reacting plays, simply forcing the market back down again. For an industry that grew addicted to megaprojects, this will take some major adjustment.

As for demand, it can't be said, either, that the period of cheap oil put rockets under consumers. Yet helping the world economy and, in doing so, hoping to stimulate oil-demand growth was one of former Saudi oil minister Ali al-Naimi's aims when he decided Opec should let the price slide.

It hasn't turned out that way. Demand will rise by 1.2m barrels a day this year and the same in 2017, reckons the International Energy Agency (IEA). But that's down on last year's growth. It's less than the increment in 2013, when Brent sold for more than twice the price it has averaged in the past 18 months. In fact, the last time oil was as cheap as it has been throughout 2016, in 2004, oil-demand growth was more than double that
expected for this year.

Grasped by prices

None of this was foreseen by Opec in the autumn of 2014. That October, the group's secretary-general Abdalla el-Badri predicted that prices as they were then-just over $80/b-would shut down half of US tight oil supply, or 2m b/d, within a year. But Brent more than halved in the months after, and tight oil output kept growing. The fall has amounted to about 0.7m b/d and the bottom may have been found.

The counter-argument to all this is that rising non-Opec supply had boxed the group into a corner. The market in late 2014 was a falling knife-hard to catch and dangerous to anyone who tried. Withdrawing supply to prop up prices, as Opec had done in 2008-09, would simply have kept marginal producers and rivals afloat. Saudi Arabia feared repeating their 1980s experience, when the kingdom had more than halved its output but failed to rescue the price. In 1985, it reversed policy and opened the taps, flattening other producer economies (including the Soviet Union's).

Falih referred to this recently too. "Now consider if Opec had cut production to maintain supply-demand balances," he said in London. "The effect would have been to encourage continued investments in expensive resources like shale, oil sands, deep sea and the Arctic, etc. This process would have continued with Opec having to successively cut production year after year."

But producers sell oil to make money-and the strategy has badly damaged Opec's income. In the months preceding the November 2014 meeting, its oil output averaged 30.4m b/d. The group's income that year was $0.75 trillion. Its average output so far this year has been 33.11m b/d and it is forecast to earn in the region of $338bn.

The drop in cash flow-unexpected by Opec insiders back in 2014-has been devastating for some of the group's economies. Saudi Arabia, its lynchpin, and the kingdom's allies in the Gulf could resist the pleas of Venezuela, Iraq and other members facing financial and political ruin. But since 2015, the pain has reached the Riyadh and other Gulf capitals too. Jadwa, a Saudi bank, says the kingdom's GDP growth slowed in Q2 for the fourth consecutive quarter. It dropped its forecast for expansion in 2016 from 1.7% to just 1.1%. In 2014 and 2015, according to the World Bank, Saudi GDP grew by about 3.5%, but in the years before often neared 10%. Since September 2014, Saudi Arabia's stock exchange, the Tadawul, has lost almost 50% of its value.

The kingdom's foreign-currency reserves topped around SAR2.8 trillion ($0.746bn) in mid-2014. Two years later, says Trading Economics, a financial-data provider, they sit at about SAR2.1 trillion-a drop of almost $200bn. The alarming pace of the draw-down and deterioration of GDP growth helped prompt the radical thinking from Mohammed bin Salman, the kingdom's powerful deputy crown prince, and his advisors: the sale of a stake in Aramco, Saudi Vision 2030, the eradication of fuel subsidies and even talk of de-pegging the riyal. Saudi Arabia embraced international markets in October when it raised $17.5bn in its first sovereign bond issue. The sweeping pivot from oil is creating a diversified kingdom more willing to seize a traditional approach to financial markets, it seems.

But now the radical is to be tempered with something more reliable and familiar: supply-side management. Tight oil's staying power was, it turns out, greater than the patience of Gulf monarchies to tolerate more economic stagnation. Russian production, at new highs in September, could not be contained. Opec members produced as much as they could, but underestimated American free-market ingenuity and Siberian staying power.

The pledge to cut supply-to be ironed out at the Vienna Opec meeting in late November-won't necessarily work. All kinds of horse-trading between members is necessary first, and a sceptical market is waiting for evidence that it's all more bluster from a sclerotic organisation. But don't ignore how significant the policy shift is. Opec lost this battle-and it knows it. It is tired of cheap oil.

This article is part of a report series on Opec. Next article: Shale v Opec

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