Saudi Arabia reluctant to pull back Opec export volumes
Opec’s heavyweight is no longer prepared to bear the brunt of the group’s cuts. Losing on price and volume share is to be avoided at all costs, writes Bill Farren-Price
The collapse in oil prices in October has brought the oil market’s focus firmly back on Opec and its dominant producer Saudi Arabia, the one country within the organisation whose size and credibility enable it to put a new floor under oil prices.
At the time of writing, speculation about a possible price war resulting from a supposed reluctance by Riyadh to pull back export volumes is the dominant theme on trading floors. Some of the tactical messaging by the Gulf’s oil superpower certainly seems to suggest there is no urgency in Riyadh to pull the oil market out of its nosedive by cutting output. But while there is a list of good reasons why a new output deal will be tough to deliver, you would have to be brave to bet against an oft-stated Saudi desire to keep oil prices in the $100 a barrel zone. A deal may take time to negotiate, but don’t rule it out.
After three years of relative oil-price stability, the accelerating slide in oil prices seen in October has rocked producer nations whose fiscal budgets are underpinned by the notion of stable $100/b oil. Brent’s near-30% decline from a late June high near $115/b reflects not just the weak fundamental outlook but also a lack of confidence in Opec’s ability or willingness to deliver supply cuts and market confusion about Saudi Arabia’s readiness to tolerate lower prices.
Market context has also been predominantly bearish: since the June price spike driven by Islamic State’s takeover of Mosul in northern Iraq, oil price action has been one-way, with geopolitical risk washed out by the relentless rise in non-Opec (read US) supply, softer demand in China and Europe and a firming dollar as quantitative easing (QE) measures are reversed. After years of stability and before that rising prices, Opec once again faces the sort of market balancing crisis not seen since 2008 and before that 1999.
Limited communication from Opec and its senior producer over this period has led to a barrage of press speculation about Saudi Arabia’s price discounts, a tactic aimed at maintaining the kingdom’s Asian market share in the face of stiff competition from other Gulf producers, including Iraq, Iran and Kuwait.
There is little debate that headlines that speak of Saudi policy-makers preparing markets for lower prices, being content to run a budget deficit or strong-arming customers into taking full allocations, have poured fuel on the fire, sending oil prices down at speed. Investors appear to have ruled out the near-term possibility of a coordinated cut in output.
But it would be wrong to confuse Saudi tactics with long-term strategy. Saudi messaging on the kingdom’s tolerance for lower oil prices is a means of reminding other producers that Riyadh is no longer happy to bear the brunt of supply adjustments as it has so many times in the past. The message to other producers also feeling the pain of sliding revenues is clear: by all means, come and discuss a multilateral deal to cut output, but do not expect Saudi Arabia to carry the can on its own this time around.
Despite the noisy headlines, formal Saudi policy has not changed. The petroleum ministry expects rising winter demand to help clean up oil on the water and eat into inventories. The kingdom thinks lower oil prices may be a temporary phenomenon and continues to target prices around the $100/b level. For 2014 and in the absence of a new Opec agreement on supply, Saudi export volumes will be maintained, avoiding the risk of ceding market share either to competing Gulf producers, or in the longer term, to non-Opec suppliers.
But discounting is unlikely to be sustained in the long term and it would be wrong to rule out Saudi engagement in serious discussions on output cuts. It is simply that Riyadh wants other producers to understand that unlike the last three years, when the kingdom was able to fine-tune supply unilaterally, a cut in output will need to have more fathers.
The present Saudi strategy is more subtle than it might appear: the learning point from the 1980s, when Saudi Arabia oil production more than halved amid falling prices, is not that discounting is unproductive per se, but that losing both on price and volume is to be avoided at all costs. This means that for Riyadh, output cuts need to be credible and significant to guarantee a market response. There is no desire for a piecemeal approach that would see a series of limited output cuts chasing the price lower, with the market continuing to test Opec’s resolve, as it did in the 1980s. If Saudi Arabia cuts output, it will be part of a wider deal.
But unlike past shock-and-awe cuts (The Hague in 1999 or Algeria in 2008) there are reasons why a dose of Opec supply restraint might take time to transmit effectively to flat prices. A reduction in Gulf heavy, sour crude, especially if Libya is left out of a deal, would do little initially to help soak up the Atlantic basin glut of light, sweet crude.
Banking on LTO economics
There is another element to Saudi and Opec thinking: that lower oil prices will take some of the froth off new non-Opec supply and make some light, tight oil (LTO) projects in the US uneconomic, helping in time to rationalise the broader non-Opec supply picture. This view has been expressed in Opec circles for some years, but the challenge is identifying the correct tipping point. Official comments suggest that Opec would expect to see a supply response with sustained WTI oil prices below $90/b, while US LTO investors believe growth in US shale oil production would halve at $70/b WTI – but that would still imply annual output growth from the US of 500,000 barrels a day (b/d).
If US LTO production is entrenched and lower price circuit-breakers fail, the question is whether Opec can negotiate a deep deal that not only wraps up the organisation’s remaining undisrupted producers (Libya and Iraq at current output are likely to be left to rebuild volumes as best they can) but also brings in credible contributions from non-Opec producers including Russia and Mexico. Such a grand bargain would be difficult but not impossible to deliver.
It would require credible and significant cuts from GCC member countries and the sort of commitment from non-Opec producers last seen in the late 1990s. Russia’s bilateral relationship with Opec has warmed over the past year and Moscow could support an output deal even though its historic control of exports in previous bouts of cooperation has been patchy.
Another challenge will be the mechanics of cutting. Opec’s internal system for managing output discipline is rusty after years of neglect. Agreeing baselines for cuts, working out how an overall cut should be shared within the group and establishing agreed production data has made it more difficult in the past for the organisation to communicate its intentions to the market. But the political will to stabilise oil prices should still trump these difficulties.
It may appear counter-intuitive for oil prices to be falling just as the Middle East conflicts in Iraq and Syria are intensifying and Russia’s confrontation with the West over Ukraine drags on. There are two principle reasons for this. First, any cut agreement would also increase notional spare capacity, providing a further buffer against supply disruption and thereby inoculating oil markets against geopolitical risk. At present, spare capacity within Opec is assessed at 3 million b/d, most of which resides in Saudi Arabia.
A cut agreement would boost this number, pushing concerns about a supply crunch due to political instability onto the back burner. In fact the geopolitical risk in the Middle East and North Africa region is now almost entirely focused on the possible return of Iranian barrels if a nuclear deal can be struck over the next month; a recovery of sorts in Libya and the continued expansion of Iraqi mega-projects. Iraqi export bottlenecks are now holding back in excess of 600,000 b/d of available wellhead capacity as the southern oilfields operate normally despite the fighting with Islamic State around Baghdad and further north.
This positive supply outlook can only put more pressure on an oil market characterised by a sharp weakening of fundamentals in the second half of 2014. The International Energy Agency’s (IEA) demand revision in October’s monthly report undermines any reliance on a rebound in fourth quarter oil demand. Behind the hefty downwards revision of global oil demand growth by 210,000 b/d to 0.7m b/d is the huge reduction in the agency’s expectation of third and fourth quarter growth, down 350,000 b/d and 390,000 b/d respectively, meaning that demand in the fourth quarter will rise just 500,000 b/d in the final quarter versus the previous quarter. The latest revision nearly halves the agency’s January demand growth view of 1.3m b/d for 2014.
Opec’s demand view is rosier but is clearly due a major downgrade before the 27 November meeting. Opec held its 2014 oil demand growth figure unchanged in October at 1.05m b/d and projects a reasonable 540,000 b/d demand increase in the fourth quarter versus the third, or a very strong 2.39m b/d increase in the fourth quarter versus the second quarter (comparable actual data for 2013 showed a 1.9m b/d increase).
It is difficult to see how Opec comes to this conclusion and how second-half demand growth will so easily exceed 2013 given the extra economic headwinds coming from the European and Chinese slowdowns and the impact of Russia sanctions on European and Russian growth.
The latest downwards demand revisions also mean that the call on Opec is set to fall even further in 2015. Opec expects demand for its crude of 29.2m b/d in 2015, 1.3m b/d below present production levels. If Opec brings its demand view into line with the IEA’s, expect the call on Opec to fall below 29m b/d, implying the need for greater corrective measures on supply if market balance is to be restored.
Fiscal oil price requirements are another factor often cited as a driver for oil supply strategy by Opec producers. Saudi Arabia’s 2014 budget requires an oil price of around $95/b to balance spending including discretionary investments – but without spending on industrial cities, universities and other major capital items, could balance at closer to $70/b.
Saudi Arabia has huge foreign exchange reserves to draw on and could opt to run a budget deficit as it did in the 1990s. These are not just dry, theoretical calculations. Already there has been plenty of public commentary about falling oil prices, a subject open for lively public debate in the kingdom, given the public finance reliance on oil income.
Bill Farren-Price is an expert in Middle East and North Africa region oil policy. He is founder and chief executive of Petroleum Policy Intelligence