OPEC Math Misses the Point

The Kingdom isn't a pushover for a deal on production cuts.

Saudi Arabia’s energy minister Khalid Al-Falih said Thursday he's "optimistic" that the agreement OPEC reached in September to limit supply will be implemented, with individual output ceilings for member countries. But don't mistake him for a pushover.

The economics of a cut are compelling, but there's more to it than just doing the math -- and this could mean the group fails to reach a deal when it meets in Vienna on Nov. 30.

An output cut of just over 1 million barrels a day would only have to boost prices by $1.60 a barrel for producers to be better off. Most people would say prices would rise more and that makes doing a deal a no-brainer.

So why don't they do it? Because it's not about the money...at least not for Saudi Arabia.

Doing The Math

The effect of output cuts and price rises on OPEC oil revenues

Source: Bloomberg

NOTE: Revenue is calculated as production volume times price.

The country knows it has to break its oil dependence and has an economic program to achieve that. Meanwhile, it still has plenty of foreign reserves, and plenty of room to borrow. Quite simply, Saudi Arabia is not on its knees.

It may prefer prices to be higher than they are now and it almost certainly still wants to be seen as a "team player" within OPEC (hence its support for action now), but it is not prepared to carry a disproportionate share of the burden. Saudi Arabia may want an output deal, but not at any cost.

The roots of this trace back to Nov. 2014, when the Kingdom refused to cut its output to support prices and subsidize high-cost rivals, rejecting the role of the world's swing producer.

This change of heart was inspired in part by the surge in U.S. shale oil production -- which was rising by 1 million barrels per day each year at the time -- in part by the growth in Iraqi output and in part by a re-evaluation of the long-term future of oil.

Saudi concerns over peak oil demand have changed its calculation of the long-term value of reserves in the ground. For most of the last 50 years they were seen as appreciating assets, whose value could only rise in the face of future scarcity. More recently a fear has surfaced that they could be wasting assets, falling in value as oil demand peaks and then wanes, while competing supplies vie for a dwindling market.

As I wrote in May, Saudi Arabia has finally heeded the warning issued in 2000 by former oil minister Sheikh Zaki Yamani, that the Stone Age did not end because of a lack of stones, and the oil age will not end for a lack of oil.

Saudi Oil Surge

Output has risen by more than 2 million barrels a day, or 25 percent, since the start of 2011

Source: Bloomberg

The kingdom has recently clarified its four pillars of participation: the cuts must be collective and equitable, while the deal must be transparent and credible. This is not really any different from what they have been saying since they launched OPEC on its current strategy two years ago.

And this is where the problems arise. Saudi Arabia is still not willing to contemplate an agreement where Iran doesn't share the pain. Iran's leaders cannot accept a deal that restricts the country's future output growth while legitimizing the surge in Saudi supply, which has risen by more than 2 million barrels a day over the last five years. To do so would raise the risk of a hard-line candidate winning May's presidential election there, undoing President Rouhani's progress in normalizing relations with the rest of the world.

Transparency and credibility require that the deal is based on mutually agreed baselines for cuts, but those don't exist. Iran, Iraq and Venezuela each claim production levels more than 200,000 barrels a day above the external estimates that OPEC says it will use as a basis for the deal.

More Than You Say

Most members say OPEC's secondary source estimates of their production are too low

Source: OPEC

NOTE: Official production figures minus secondary source estimates published by OPEC NOTE: OPEC did not report official production numbers for Gabon, Indonesia or Libya for October

These ought not to be insuperable obstacles, and may indeed be overcome at the eleventh hour, but don't be surprised if Saudi Arabia is willing to let the deal die if its conditions aren't met -- just as it did in April.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

    To contact the author of this story:
    Julian Lee in London at jlee1627@bloomberg.net

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