Why Saudi Arabia remains the linchpin of Opec

Three interesting things came out of Friday’s Opec meeting. Saudi Arabia bared its teeth, and compelled other members to agree to deeper production cuts. Russia took up a greater share of the burden, though winning a concession. And most importantly, the organisation has laid out that a relatively gloomy near-term outlook overshadows a rosier medium term. Saudi Arabia’s production has consistently been below the amount it has been allowed under the November 2016 Opec+ pact, even ignoring the effect of the attack on the Abqaiq processing facility in September. Now, it has accepted a further 1.6 per cent cut from its previous target, but the kingdom stated it will produce even less, an effective 5.8 per cent below target, as long as other members comply. In return, the serial under-compliers Iraq and Nigeria have accepted slightly smaller cuts, around 1.1-1.2 per cent each, but with the clear demand that they do not exceed their limits. Iraq even says that the autonomous Kurdistan region has agreed to cap its production. It will be interesting to see how this is enforced, given that the Kurdish region has new fields expanding output. Kuwait and the UAE have agreed to targets lower by about 2-2.1 per cent each, a relatively easy task for Kuwait which was barely above this level in October anyway. So instead of continuing its unilateral overcompliance, Riyadh has put the other members on notice that they have to live up their commitments. As opposed to the 1990s, when “good” compliance was in the range of 60-70 per cent, the current pact has generally achieved adherence close to 100 per cent or even better, with losses from members Iran and Venezuela and good compliance from leading members such as the UAE and Kuwait offsetting some lapses from others. Yet Saudi Arabia does not want to run the risk of continuing to be taken advantage of. This is even more important given the departure of small Opec producers who are now unconstrained. In the initial round of target-setting for the Opec+ alliance, all the non-exempt Opec countries committed to cut almost the same, around 3.5 per cent, from their baseline. The non-Opec adherents, including Russia, Oman and some others, agreed to much smaller curbs. Compared to the past, Russia has now agreed to a more significant cut for its crude output, but the impact of this is softened by an important concession. Russia produces about 833 000 barrels daily of condensate, a by-product of its massive gas output. Condensate was included in the previous deal but is now exempt – as it always has been for Opec members. The new arrangement is more sensible, though there is always a loophole – much used by Nigeria – for reclassifying light oil as “condensate”. The third aspect of this agreement is what it says about the organisation’s short and medium-term views. Before the meeting, the market consensus was that production cuts would not be deepened but might be extended beyond the next meeting in March. Instead, the opposite has happened. The market responded positively, with Brent crude rising 1.6 per cent. The near-term outlook is gloomy, with a further wave of non-Opec supply forecast from Brazil, Norway, Guyana and continuing in the US. The demand forecast has perhaps improved a little recently but is influenced by Chinese economic fortunes and the roller-coaster of presidential trade war tweets. If the world economy dodges a recession in 2020, the situation may be brighter in the second half of the year. A price of $60 or so per barrel is still healthy. The physical market appears quite tight, and global inventories have fallen back to around the five-year average. After 2020, the wave of megaprojects that sustained output outside shale and Opec will ebb. Opec is betting that this time, it has killed off shale as a serious competitor. In 2016, American output fell under the strain of low oil prices, then rebounded as the Opec+ pact took effect. Now, the shale sector is unloved by financiers, independent firms are struggling to raise capital, productivity gains have slowed, the number of rigs drilling has dropped consistently since the start of the year, and shareholders are demanding dividends instead of growth. Predictions for output gains next year that rival this year’s look increasingly over-optimistic. But the producers’ organisation is still treading a fine line. It has not usually been adept at changing course quickly. Significantly higher prices could rekindle investors’ interest in oil, change the narrative back to growth, and reward the major oil firms such as ExxonMobil, Chevron and Occidental that have bet heavily on shale. They would also represent a negative shock for the global economy. And over the next few years, the expansion of electric vehicles will start having a material effect in reducing oil demand. For now, other Opec+ members have been pressed to come into line. After March, Opec as a whole may have to execute a volte face. Riyadh’s growing command may be required to shift gears up as well as down. Robin M. Mills is CEO of Qamar Energy, and author of The Myth of the Oil Crisis