For Saudis, Even a Small Oil Cutback Is a Big Deal
This week’s OPEC meeting about a global production cut is in crisis before it has even begun. Pre-summit discussions with non-member oil producers such as Russia were canceled. The Saudi Arabian government now warns that members may leave Wednesday’s talks in Vienna empty-handed -- an outcome that would be sure to trouble markets.
The confusion is understandable. Almost exactly two years ago, in the face of weakening prices, Saudi Arabia convinced the other members of OPEC that the best course of action was to do nothing. The new shale-derived petroleum being produced in the U.S. had upset OPEC’s traditional role: If members cut its output to boost price, they would only be inviting more shale oil to be produced in short order, rapidly eroding any resulting price gains.
Arguably, the same argument holds water today. Yet, now, Saudi Arabia seems eager to convince others to cut production. Why has Riyadh changed its tune?
Some explain the shift by simple math: The economic pain of two years of low oil prices may finally induce cooperation on cutbacks among the unlikely cohort of oil producers. There is certainly some truth to this explanation. Oil producers are laboring under slashed revenues and Saudi Arabia is no exception. Even a temporary relief from low prices might be seen as worth the effort.
Yet it’s worth considering another possibility as to why Saudi Arabia may be so interested in a production cut now. It can still be concerned about shale -- as it was in 2014 and still should be today -- but at the same time see value in production cut on Wednesday. To understand this thinking, one has to dig deeper into exactly what the Saudis have been up to over the last two years.
The oil strategy Saudi Arabia embarked on in 2014 prioritized market share over price. The kingdom (and many other OPEC members) ramped up production to all-time highs and sought to make the deepest inroads possible into the world’s fastest-growing markets such as China and India. By July 2016, Saudi Arabia was producing at a record rate of 10.7 million barrels per day, despite prices struggling well below $50 a barrel.
Some industry experts saw this approach as an effort to drive North American shale, which is more expensive to produce than Middle Eastern oil, out of the market. Others said it was mainly intended to hurt the Saudis’ geopolitical rivals: Iran and Russia.
But Saudi actions might be better understood as part of a fact-finding mission. The kingdom wanted to learn more about this new shale resource. At what price would U.S. producers call it quits? And how quickly would they do so? Moreover, the kingdom also wanted to learn more about how much additional production Iran and Iraq could bring on the market in a new geopolitical environment. Riyadh needed this information to determine what role it could play in markets going forward and what sort of future investments made sense.
In many respects, Saudi Arabia has gotten its answers, even if they are not the ones it wanted. Iran and Iraq together have increased their collective production by an additional 2 million barrels a day from since the end of 2014. U.S. shale production proved remarkably resistant to the price plunge, at least for the first year. Even when production began to decline in May 2015, cost-cutting and improved technology allowed significant amounts of shale oil to be churned out -- at prices far below what most observers, Saudi and otherwise, thought possible.
But Saudi Arabia, and the world, is still missing a very important piece of the puzzle. Just because we have a better understanding of how shale production reacts to a declining price does not mean we know how it will respond to a rising one. Naturally, this piece of information is important. It, more than any other factor, determines whether OPEC and Saudi Arabia will be able to influence oil price by calibrating production for the foreseeable future.
Saudi Arabia’s original plan was probably to pursue its market-share-over-price approach until the forces of supply and demand balanced themselves, and the per-barrel price began to rise on its own accord. Then, Riyadh would studiously watch the response of U.S. shale production. What price was necessary to coax the drilled but uncompleted North American wells to be produced? What price was required to induce new investment? What was the lag time between reaching that price and seeing new production? Saudi Arabia could take notes -- protecting its market share, learning about this new oil source, and factoring this knowledge into its oil policy going forward.
The market, however, has been slow to do its work. Wednesday’s meeting offers Saudi Arabia a chance to fast-forward the balancing of the market. If it can convince a few other producers -- within and outside of OPEC -- to cut alongside it, it might generate a lift in the price. While unlikely to be substantial, the boost may be sufficient for Saudi Arabia to get some of the information it needs on shale’s behavior.
The beauty of this -- from Riyadh’s perspective -- is that it could come at little cost to its market share. In the past, Saudi Arabia has generally cut production around this time of year anyway. Given its record production in the past summer and fall, Riyadh could cut half a million barrels and still be pumping out nearly the same amount it was producing the end of 2015 -- more than one year into its pro-market share approach.
Even better, this production cut may not be fully reflected in Saudi Arabia’s exports (and therefore market share); the domestic need for it to burn oil to generate electricity diminishes as the desert cools for winter. Such a cut, however, could be enough to induce others, including Russia, to freeze or cut a bit from their own production -- helping put a higher floor under the price.
In this sense, Saudi Arabia may have nothing to lose, and at least something to gain, from cutting production modestly. The benefits for Riyadh of a situation in which prices are buoyed for some time before shale reacts are obvious, particularly during a year in which it is preparing to publicly list part of its national oil company, Saudi Aramco, for the first time.
Even what may look like a worse-case scenario -- in which an OPEC production cut leads to higher prices only for a short period before U.S. shale production increases and pushes prices back down -- would still be of some value to Saudi Arabia. While hardly ideal, it would give Riyadh the important last piece of the puzzle needed to formulate the wise longer-term oil strategy in an increasingly complex market. This is critical if Saudi Arabia has any hope of managing the ambitious transition away from oil that its new leadership envisions.
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