OPEC ‘understanding’ signals a reversal of Saudi Arabia’s crude strategy

A meeting of OPEC oil ministers in Algeria. Picture: AP

It won’t be clear until November whether the “understanding” OPEC members reached overnight actually translates into production cuts but what is apparent from the nature of the understanding is that the cartel has finally recognised that the Saudi Arabian strategy that has driven the oil price down by about 60 per cent over the past two years has been counter-productive.

At their informal meeting in Algeria, OPEC members recognised that a production cut was necessary to lift oil prices and appear to have agreed that their collective output levels need to be cut by about 700,000 barrels a day from their current levels of 33.2 million barrels a day.

What hasn’t been agreed is the detail of those cuts, and where they will fall, although it appears that the Saudis are going to have to wear the brunt of them.

A committee has been formed to work through the apportionment of the cuts and report to the next meeting in Vienna on 30 November but the Saudi Energy Minister, Khalid al-Falih, is reported to have said that Iran, Libya and Nigeria could be allowed to produce at “maximum levels that make sense” even if other producers curtailed their production.

Previous attempts to stabilise the market foundered over the Saudis insistence that Iran, in particular, freeze its production.

Iran has made it clear that, after years of punishing sanctions, it has no intention of agreeing to a supply freeze until its production gets back to pre-sanction levels of about four million barrels a day. Iran is currently producing around 3.6 million barrels a day. Libya and Nigeria are trying to restore production volumes after their supply was disrupted by internal conflicts.

Even if OPEC could agree to production cuts and how they might be allocated there is no guarantee that supply would fall. In the past, OPEC and, in some instances non-members like Russia, have agreed to constrain supply but subsequently increased production.

The likelihood of some sort of deal in November has, however, increased because the market-share strategy that the Saudis embarked on back in 2014, when oil prices were above $US100 a barrel, has not worked as envisaged.

Where the Saudis expected to quickly regain market share by driving out marginal production (and producers), particularly the US onshore oil producers, instead the prolonged supply glut has flattened the cost curve.

While there has been a reduction in US shale oil production from its peak in 2015, it has proven far more resilient and adaptive than anyone anticipated and drilling and development costs have fallen dramatically as the producers have responded to the plunge in prices.

In recent months, drilling activity (which had crashed about 80 per cent from its peak) has been gradually picking up and, if the price were to move sustainably above $US50 a barrel (it spiked to just under $US47 a barrel on the OPEC news overnight), that activity and subsequent production volumes would accelerate.

Not only hasn’t the strategy produced the kind of permanent structural change the Saudis appear to have wanted, but the duration of the period of depressed prices has increasingly hurt OPEC members themselves.

Earlier this week, the Saudis, having already cashed out about 20 per cent of their vast foreign reserves to maintain spending and plunged into budget deficits (a deficit of $US98bn last year), announced they would cut ministers’ salaries by 20 per cent and cut housing and car allowances and overtime bonuses for public sector employees.

It had previously announced reductions to a range of government subsidies and increases in service charges as oil revenues fell away and economic growth stalled.

It is a sign of how much the lower oil price is hurting the Saudis that they are prepared to make some concessions to archrival Iran and to wear the bulk of the production cuts.

Whether OPEC can actually agree to reduce production in November, and perhaps obtain some assurances from key non-members like Russia, to stop increasing their supply, is an open question.

It might also be an irrelevant one if any OPEC pullback results in increased US onshore volumes.

The effect of the OPEC strategy has, by so dramatically flattening the cost curve, been to surrender their ability as the low-cost producers to influence/control oil prices.

The marginal producers now have considerable influence over prices, which may produce a structurally lower oil price into the distant future.

For economies built on oil and gas revenues, which is the case for the OPEC members and Russia, the trade-off of price for volume gains hasn’t been a favourable one — they’ve surrendered more in margin than they’ve gained in volume.

With the latent capacity in the US and global oil inventories at record levels there is a near-to-medium-term ceiling on the price, albeit one perhaps higher than the current price, regardless of any OPEC agreement of the order envisaged.

Longer term, the savage impact of the low prices on oil and gas industry investment in new reserves and production might, in a market where demand does edge up each year, help to produce somewhat stronger prices until exploration and development investment has recovered.

OPEC appears to have belatedly recognised that its prior conviction that the market would rebalance in the last few months of this year, or early next year, was misconceived and that collective action is now more urgently required if it is to have any impact on oil prices within the next 12 months or so.

That realisation, however, has come too late to spare its members from the sector’s pain or to enable it to regain the level of control it once had over the oil market.