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Saudi Arabia's efforts to balance the market are working

The kingdom’s efforts to balance the market are working. It may herald a new era of oil abundance

Another oil-price cycle may be coming to a close. Supplies are surging, demand from a battered world economy is tepid, and Saudi Arabia, the world’s largest crude exporter, is determined to deflate the market and revive its global customer base. Iran remains a wildcard. But longer term, the spectre of a 1980s-style price slump is in the minds of some analysts.

No one should get carried away – yet. Despite a $30 a barrel plunge in oil prices since highs set in April, they are still expensive. “Memories are indeed short: crude prices remain very high in historical terms,” the International Energy Agency (IEA) noted in June, as prices slipped beneath $100/b, and they continue to stifle consumer economies, “acting as a drag on household and government budgets in OECD and emerging markets alike”.

A collapse is not imminent, either. Amid frenzied buying on 29 June, Brent soared by 7% to $97.80/b after an EU summit in Brussels, where Germany at last agreed to underpin some kind of banking union and financial bail-out of southern European countries. As equity prices surged, the euro strengthened against the dollar and oil markets followed sentiment. Watching the screens it was easy to think the oil-price weakness of recent weeks had ended.

Threats to supply still linger. Conflict in South Sudan, Syria and Yemen, as well as unplanned outages elsewhere outside Opec, could keep about 1.2 million barrels a day (b/d) of oil off the market in the second half of this year, believes the IEA. Just as significantly, negotiations over Iran’s nuclear programme have ended in deadlock. If a compromise is reached – and the Moscow summit in mid-June between Iran and six other countries left no one enthused with progress – it will come after the US election in November, believe diplomats. In the meantime, US and EU sanctions aiming to cripple Iran’s oil industry are now in place. As much as 1m b/d of Iranian oil could be removed from the market – or more, if Iran shuts the Strait of Hormuz, as some of its politicians wish.

The kingdom has its say

Enter Saudi Arabia. The kingdom has had enough of soaring oil prices and, despite the objections of some Opec members, has launched a deliberate campaign to bring them down. “It comes from the highest level,” said Saudi sources. That means King Abdullah. The strategy began in March, following a meeting of the country’s council of ministers, chaired by the king. The kingdom wanted to address the “negative impact of rising oil prices on the world economy”, said a statement then. Since the meeting, oil minister Ali Naimi has stepped up with words calculated to reiterate the message. Saudi Aramco, the state firm, has launched ships laden with Saudi crude to meet any requests for supplies. The kingdom’s actions, Naimi said ahead of the Opec meeting in Vienna in June, had acted as a “type of stimulus to the European and world economy”.

Led by Saudi Arabia and other Gulf Opec members, Opec’s output is soaring, more than offsetting any loss in Iranian oil or rapidly closing gaps left from Libya. Production of 31.6m b/d is 1.6m b/d above its own production ceiling, set last December. Effective global spare capacity remains tight, said the US Energy Information Administration (EIA) in its latest bi-monthly report on worldwide oil balances, but the market has “loosened”, largely thanks to Opec.

With worries about the global economy – and what the downturn may do to demand – in the minds of Opec’s price-hawks, the soaring supply gave a backdrop to another testy meeting in Vienna in June. Even a bureaucratic decision about who would replace Abdalla El-Badri, whose term as secretary-general ends this year, was the occasion for more squabbling. That decision was deferred.

Saudi Arabia went into the meeting pointing to Opec’s own figures, which suggest global demand for oil this year will rise by 900,000 b/d, and the call on the group’s crude in the second half of the year would be around 30.74m b/d. This outlook would justify raising the ceiling, Naimi suggested. Oil ministers from Venezuela and Algeria instead argued that, given the weakness in the global economy, the group should cut now to stop a slump in prices.

Within the meeting, said sources, Iran and Iraq, joined by Algeria and Venezuela, aligned against Saudi Arabia, demanding that it restrain production. But which of the hawks was willing to cut its own output, too? None stepped forward and the meeting ended with an impasse, Opec agreeing to leave its 30m b/d production ceiling untouched.

El-Badri told a group of journalists after the meeting that “everyone will respect” the ceiling, restraining output to bring it down to 30m b/d. Opec’s production would begin to fall in July, he said. According to a newswire survey, however, the group’s June output has barely shifted: at 31.63m b/d, it was just shy of the high set in April.

Opec’s own numbers, though, are confusing. El-Badri said the 30m b/d ceiling agreed last December was based on production figures for each member set in November 2011. No individual quotas exist, but output levels recorded then would guide the levels expected now, he said. Yet Iraq and Libya, which have added about 1.3m b/d to production since November, were not part of the November agreement. Saudi Arabia’s May output, meanwhile, was only around 300,000 b/d above its November production, or half the increase of Iraq in the same period. So it’s unclear which members would cut back to bring the group in line with the ceiling.

In any event, it isn’t going to happen. After the EU agreement sparked a rally in late June, prices are where Saudi Arabia wants them. El-Badri told Petroleum Economist in Vienna that oil prices beneath $110/b would be no threat to global economic growth. But the IEA and consumer governments disagree – and so, critically, does Saudi Arabia. Ministry sources are adamant that the kingdom doesn’t want any supply gaps to push prices back up into the redzone, above $100/b. “We’ll continue to honour the requests of our customers within the context of a balanced market,” said a source. “Right now, what is important is the health of the global economy.”

Saudi Arabia is also tiring of the debate. If Europe and the global economy collapses, runs the thinking in the ministry, global oil demand will suffer. The burden to cut back production won’t fall on Algeria and Venezuela, but on Saudi Arabia. The kingdom has more to lose.

As for Iraq’s Opec alignment with Iran against Saudi Arabia – a move orchestrated between the Nuri al-Maliki government in Baghdad and the regime in Tehran, according to some sources – the strategy carries risks. If it continues, Saudi Arabia may wonder if Iraq should itself begin to adopt some group discipline, in the form of a quota. So far, the kingdom has watched patiently as its neighbour builds up production capacity, deeming the extra oil to be welcome in a tight market. Iraq should beware pushing this generosity too far.

The animosity between the Gulf producers, on one side, and Iran and Iraq on the other falls in line with some conspiracy theories arguing Saudi Arabia would stomach a slump in oil prices if it meant the Shia Iraq and Iran suffer first. Both depend on a far higher oil price – well above $100/b – to keep their fiscal budgets afloat. While it keeps producing 9.9m b/d, though, Saudi Arabia can cope comfortably with Brent prices as low as $87/b, said Leo Drollas, director and chief economist of the Centre for Global Energy Studies (CGES), in London.

To be sure, despite Saudi assurances that it is not seeking to replace sanctions-hit Iranian output, the kingdom isn’t turning away requests from customers left in the lurch by the embargo, either. That must be galling for Iran, whose market share is depleting and its economy crumbling, all without a spike in oil prices that would hurt the countries doing the sanctioning. Nonetheless, pointed out Drollas, Saudi Arabia won’t wish Iran’s economy to deteriorate too severely. “They don’t want Iran to become so weak that they become dangerous.”

With Saudi spigots open, though, the market’s fundamentals will increasingly look bearish, believe some analysts, especially if the extra oil on its way to consumers meets with weaker-than-expected demand. Already, crude-oil stocks are building significantly. In June, the IEA said OECD inventories for May are above five-year averages: at 59.4 days, 1.9 higher than the norm. The IEA said stocks built by around 1m b/d in May and June alone. The CGES forecasts that the stock increase will have been 2.5m b/d in the second quarter, on top of a rise of 1.3m b/d in Q1: “a massive build,” said Drollas. Brent prices reflect the loosening of the market, with backwardation now periodically giving way to mild contango: traders know there is lots of oil to be found in the physical market.

If oil demand in 2012 is to rise by 800,000 b/d, as the IEA forecasts, or 900,000 b/d, as Opec predicts, then the extra oil may be needed. But those data look shaky. Demand in 2011, says the IEA, was 89.1m b/d. Yet in Q1 2012 it was just 89.5m b/d and in the second quarter fell to 88.5m b/d, leaving an average decline in consumption so far this year. That leaves a lot of oil demand to emerge in the next two quarters. Historically, those are seasonally high-demand quarters. But as global economic growth prospects waver, historical measures may not be so reliable this year. Manufacturing and other data from the US and China point to persistent economic weakness, notwithstanding the EU’s latest rescue package. So it won’t surprise anyone if Opec and the IEA begin to revise down their demand growth forecasts in the coming months.

If so, such revisions would weigh heavily on still-lofty oil prices. For now, oil bulls point to the Iran factor as a supply threat that will keep a price slump at bay. But there, too, surprises may be in store. The US’ last-minute exemption of China from sanctions now means that most of Iran’s biggest clients face no penalties from continued imports.

The regime is finding ways to keep its oil flowing. Iran is using three methods to avoid the sanctions. Payment in import-countries’ currencies, such as rupees, is one way to secure cash. At the same time, the government has handed about a fifth of its international sales contracts to private individuals, who are not covered by the sanctions and are not associated with the state oil company. Third, as previously reported by Petroleum Economist, Iran is offering steep discounts on its oil in the form of deferred-payment schemes. Typically, these have allowed payment to be made three months after delivery of the oil – equivalent to a $1.50/b discount per month. China, said a source, has upped the ante on that, too: it has begun negotiations for a six-month discount, equivalent to a $9/b discount against the going rate.

Alongside US exemptions, Iran’s canny response to the sanctions should keep some of its oil untouched – even if no one can really say how much. A recent report in the Financial Times suggested the country’s fleet of tankers was changing manifest names to evade detection, too. Some shippers are also finding ways to get insurance on their cargoes. Iran continues to claim that its crude production has not yet been affected by the embargo, which is now in place, although secondary sources quoted by Opec pegged its output in May at 3.14m b/d, more than 600,000 b/d beneath the level stated by Iran. And if the loss of Iranian oil is greater than expected, Saudi output is likely to rise still further in the third quarter to compensate, according to ministry insiders.

So the Saudi-led surge in oil supplies could begin hitting buyers just as other forces keep weakening market sentiment. Already, there are signs of fear among some analysts. Credit Suisse, a bank, said in a note (published before the EU summit of 28 June) that the Eurozone crisis could send oil prices tumbling to around $50/b this year. Other analysts have also sharply revised down their forecasts. The CGES sees Brent at $93/b in the third quarter but, “if things continue”, hitting $80 in Q4. In contrast, Goldman Sachs, the market’s relentless bull, said on 11 June that a long position in oil was “compelling”, given that Brent would rise to $120/b again in the third quarter.

Around a more distant corner

A longer-term outlook, beyond the near-term quarters, is what should really trouble Opec’s hawks. Their addiction to high oil prices isn’t just a domestic fiscal problem if markets sink – it is also a threat to their market share. A decade of rising oil prices has done what economists predicted: yielding new supplies, especially in North America, even as demand growth becomes less secure.

“Non-conventional oil owes its recent surge to a higher oil price”, Naimi said recently. It was no concern to Saudi Arabia, he added, because the kingdom “welcomes extra oil [that] will add new depth to the market, and new stability”.

That’s the official line, and other Opec members say they are relaxed about rising output in Canada and the US. The Middle East isn’t about to lose its pre-eminence as an oil-exporting powerhouse. But outside the region things are moving fast. “North America could become self sufficient in oil as well (as gas) by 2025,” ConocoPhillips’ Ryan Lance told the Opec seminar in Vienna in June. For exporters, the loss of the world’s biggest consumer would be difficult to shrug off, especially as unconventional oil and gas loom on the radar in other consuming areas, too, from Asia to Europe. Said Lance: “For too long, we’ve faced inaccurate perceptions in consuming nations of resource scarcity.” Those days are coming to an end.

And by battling for higher prices, Opec’s hawks may speed up the denouement. Beyond Iraq, the wave of oil supplies building across the world is coming from outside the group, as a decade of strong crude prices encouraged ingenuity to open the deep-water, shale- and tight-oil deposits once deemed too pricey to develop. Yet softer oil markets now would stymie some of that growth, and defend Opec’s market share. Discounted Western Canadian Select, for example, the contract for oil-sands bitumen, has already touched lows beneath $50/b in recent weeks, thanks to the drop in WTI. Further falls would begin to trouble plans for new big projects in Canada. Cheap oil defends Opec’s market share, in other words, but pricey oil is a boon for unconventional rivals.

That may not trouble Saudi Arabia, the world’s swing producer and owner of the planet’s biggest oil endowment. But it ought to worry others in Opec who can neither cope with a fall in prices nor increase output quickly enough to compete. High crude prices are not just a threat to consumer economies, oil demand and world growth prospects. They’ve also become a missile directed at Opec’s long-term domination of oil supply. Perceptions of scarcity are disintegrating with each barrel of Bakken crude that hits the market. A new cycle of abundance is drawing near.

Stability the watchword after death of Saudi crown prince

The death of Saudi crown prince and interior minister Naif is unlikely to bring a shift in oil or internal policy, say analysts, after King Abdullah moved quickly to appoint Prince Salman as his heir and Prince Ahmed to run the kingdom’s internal affairs. “For Saudi oil policy, succession arrangements will have no impact on long-standing international policies whereby the kingdom has committed to balancing global oil markets by meeting any and all customer demand, while pursuing long-term oil prices that it deems fair to both producers and consumers,” said a report by Petroleum Policy Intelligence, an oil-market consultancy. “Changes in the senior leadership may have some impact on domestic energy policy in the future, where the policy debate is more active.”

However, the frailty of King Abdullah’s health – a mischievous report from Iranian TV claimed the ruler was near death’s door last month – and a rising generation of young princes seeking position within the kingdom will continue to bring jostling for influence.

Naif was considered a hardliner, both domestically where he sought to crush Al Qaeda and other internal opponents, squashing any Arab Spring-style uprising, and in relations with Saudi Arabia’s rivals in the Gulf, including Iran.

An ‘unprecedented’ rise in supply

North America’s unconventional oil sector will lead a vast new swathe of global supply that could lead to a “glut of overproduction and a steep dip in oil prices” and make the Western hemisphere the new centre of gravity in the world’s oil sector, according to a report from the Belfer Center for Science and International Affairs at Harvard University.

The field-by-field analysis of oil exploration and production projects around the world says that output could rise by 49 million b/d by 2020, or more than twice world demand in 2011, an “unprecedented” increase that has got underway “quite unnoticed”. The revival has been “driven by high oil prices, booming investments, private companies’ desperate need to restore their reserves, and the misguided but still prevalent perception that oil must become a rare commodity”. In 2012 alone, more than $600 billion will be spent worldwide in oil and gas exploration and production, calculates the report’s author, Leonardo Maugeri, a former Eni executive.

Even after adjusting the potential production growth to account for risk, up to 29m b/d could be added. Including depletion rates, which Maugeri says have been overestimated and are typically no more than 2-3%, net additions to production could reach 17.6m b/d by 2020, yielding output of 110.6m b/d – “the most significant increase in any decade since the 1980s.”

Maugeri says the oil revival has followed an “unparalleled investment cycle that started in 2003 and has reached its climax from 2010 on, with three-year investments in oil and gas exploration and production of more than $1.5 trillion”. An average oil price of just $70 a barrel would keep this production growth in tact. Output in new unconventional formations like the Bakken of North Dakota or liquids-rich gasfields in Texas is profitable at even lower prices. US output alone could reach 11.6m b/d by 2020 (13m b/d including biofuels), or 65% of demand, forecasts the report.

An oil-price dip before 2015, says Maugeri, would have a significant impact on the production outlook. A collapse after that point, however, could leave a “prolonged phase of overproduction … because capacity would have already expanded and production costs would have decreased”. Sunken capital costs mean projects would remain on stream, even as prices dropped.

“Oil is not in short supply. From a purely physical point of view, there are huge volumes of conventional and unconventional oils still to be developed, with no ‘peak oil’ in sight,” says Maugeri. “The real problems concerning future oil production are above the surface, not beneath it, and relate to political decisions and geopolitical instability.”

The shale- and tight-oil boom in the US is not a “temporary bubble”, says Maugeri, “but the most important revolution in the oil sector in decades. It will probably trigger worldwide emulation over the next decades that might bear surprising results – given the fact that most shale/tight oil resources in the world are still unknown and untapped.” Applying hydraulic fracturing and horizontal drilling to conventional oilfields could offer up even more oil, increasing the recovery rates of already producing fields.

Libya to exceed pre-war output

Libyan output reached 1.4m b/d in May, according to the International Energy Agency, and is moving quickly to boost production beyond its pre-war levels of 1.6m b/d, its oil minister, Abdurahman Benyezza.

The country’s Opec governor, Samir Salem Kamal, told Petroleum Economist that new drilling – part of a $10bn upstream campaign – would add up to 10bn barrels of oil to reserves, which BP said amounted to 47.1bn barrels at the end of 2011.

By the end of the year, the country will have production “just above” 1.6m b/d, said Kamal, and plans to reach capacity of 2.2m b/d within five years. If the target is reached, it will cap one of the industry’s remarkable recoveries. Just a year ago, some analysts wrongly claimed that Libya’s oil output had been heavily damaged by the civil war that toppled Muammar Qadhafi, and would take years to regain pre-conflict levels.

New output from the country – alongside soaring production in Iraq, which has grown by almost 7% this year, to just under 3m b/d – poses a problem for Opec. Its 30m b/d production ceiling came into force last November, when Libya’s output was about a fifth of present levels. To accommodate its rise, say Opec officials, other members will have to trim their production: unlikely, as long as Saudi Arabia and other Gulf members seek to build global stocks and puncture a market bubble.

Production growth in Libya could yet stall. Elections on 7 July, as Petroleum Economist went to press, may bring uncertainty. Several investors say they are waiting for the outcome of the vote before pledging new upstream cash. Benyezza refused to answer questions last month at the Opec meeting about whether he would remain oil minister in a new government.

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