Opec takes a big bet by holding output
Robert Mabro, the veteran oil market observer, once said Opec should change its logo to a teabag “because it only works when in hot water”.
If that is the case, the oil producers’ cartel should have sprung into action long ago. Oil prices have fallen almost 50 per cent since mid-June to their lowest level in five-and-a-half years. Yet for the 12-nation group it is business as usual.
Led by Saudi Arabia, its largest producer, the cartel decided at its November meeting to hold output at 30m barrels a day despite calls from poorer members for production cuts to bolster prices.
Seasoned market observers are split on the reasons behind the decision at a time when supply is overwhelming tepid demand and prices are spiralling downwards.
Ali al-Naimi, Saudi Arabia’s oil minister, said on Thursday Opec had sought co-operation from other oil producers on output cuts, but “those efforts were not successful”. So it is pushing ahead with a passive strategy to let the market determine prices.
Many analysts believe Opec’s actions reflect a strategy by Saudi Arabia and its Gulf allies to preserve market share in the face of growing non-Opec supply from sources ranging from US shale to Brazil’s deepwater fields. Underlying this is a belief that lower prices will squeeze out higher-cost production and bring supply and demand back into balance.
“Lots of people have failed to recognise this paradigm shift and radical departure from prior Saudi policy,” says Yasser Elguindi of Medley Global Advisors.
“This strategy is not just about supply and demand balances in the coming weeks and months. This is about the next two or three years. They’re saying ‘$110 oil is not in our [long-term] interest’,” he says.
But Opec is taking a big gamble and short-term price pressures may hurt more than expected, meaning the cartel could still consider production cuts, some analysts say. However, Saudi Arabia has made clear it will not reduce output unless it can share the burden with Opec peers and other big exporters, such as Russia.
“We believe that a decision by Moscow to remove barrels next year could be critical to getting Riyadh to adopt a more active price stabilisation policy,” says Helima Croft, head of commodity strategy at RBC Capital Markets.
In the absence of such collaboration, Saudi Arabia and its Gulf allies have led an Opec strategy to sit tight. In some ways the outcome is the same.
“They need to give the market some time to adjust,” says Mohammad al-Sabban, a senior adviser to the Saudi oil minister from 1996 until last year.
History may reflect why Saudi Arabia is reluctant to cut on its own. In the 1980s, the oil price fell amid surging production from the North Sea. The kingdom cut production from 10m b/d to 2.5m b/d over five years but that failed to arrest the decline in prices.
In the late 1990s, Opec was also facing a long run of low prices. The Asian financial crisis depressed demand, yet Opec members flooded the market with oil, launching a price war that sent crude down to single digits. Only after oil touched $10 a barrel did the cartel cut production, in co-ordination with non-Opec states.
For Opec, the US shale boom evokes memories of the 1980s North Sea surge. The rise in US production has been offset until now by outages in places such as Libya and Iraq. But with supply coming back and a worse than expected demand slowdown in Asia and Europe, the cartel’s members are again having to confront a big new source of non-Opec supply.
“In the beginning, Opec ministers were welcoming shale, saying [it] will give depth to the oil market,” says Mr Sabban, in an unofficial capacity.
“Now, privately, they are seriously worried. Not just about the rise of shale oil production, but the rise of conventional production too,” he adds. Opec members had become used to $100 a barrel oil, he says, but had underestimated the impact of the additional supply that high crude prices would bring on.
But the jury is still out as to whether Opec will be able to tolerate a period of lower prices at any cost.
“Opec countries are going to suffer more, and earlier, than many non-Opec producers,” says Leo Drollas, an energy economist. The Gulf nations have the finances to play a longer-term game, but the economic situation will only get worse for Venezuela, Nigeria, Libya, Iran and Iraq. “Low prices could destabilise these countries,” he says. Even Saudi Arabia may have to cut spending or run a deficit.
How lower oil prices affect supply is still uncertain. While all eyes are on US shale oilfields, other more vulnerable production could take a hit first. How and when the big oil companies adjust spending plans is also unclear. This could lay the groundwork for a more boom-bust-boom market and a big price rally.
Questions about the demand picture also remain. A pick-up in the short term could push prices up, some analysts say, but the oversupply scenario might then play out again further down the line.
However, Mr Elguindi says the market is still vulnerable to security shocks. “It only takes one strategically placed bomb in Iraq and this is a whole other story.”