Why Saudi Arabia will not cut oil production

With prices sinking to a fraction of their previous highs, the era of stabilisation has drawn to a close for the kingdom, with Opec following suit. Now markets dictate outcomes, leaving the higher-cost producers to fend for themselves.

Saudi petroleum minister Ali Al Naimi ruled out any production during the IHS CERAWeek conference in Houston last week. F Carter Smith / Bloomberg

Saudi Arabia has agreed to meet next month with Russia, Venezuela and others on freezing oil output at January levels, but the petroleum minister Ali Al Naimi ruled out any production cuts in addressing a Houston conference full of US shale operators all hoping that prices might be restored to $50 per barrel or more.

High-cost producers are desperate for the kingdom and Opec to revert to their previous policy of defending some lofty price bands that would permit non-Opec producers to continue expanding output profitably, as they were able to do over the 2010-14 period.

In essence Saudi Arabia and Arabian Gulf producers have completely abandoned any price-stabilising role in the world oil market.

Although pegged prices can maximise revenues in the short run, over time adjusting output to maintain price has consistently led to erosion of Opec market share, with the main beneficiaries of price stability high-cost non-Opec producers.

Both Mr Al Naimi and the UAE energy minister Suhail Al Mazrouei have repeatedly emphasised that they will leave oil prices up to the market to determine. Mr Al Mazrouei has told this writer on several occasions that the market will end up fav­ouring low-cost producers like the UAE, and this is right and proper as a matter of economic efficiency.

That the shift to lower cost oil will take some time is evident in the way that deepwater offshore, US shale and Canadian heavy oil have stubbornly held on in the expectation of better times ahead. Yet this has all turned out to be wishful thinking, because it is clear that Gulf producers have stiffened their resolve to ride out the period of low prices in pursuit of the new long-term objective of increasing market share.

At the moment price is bearing the brunt of continuing Iraqi increases under their field redevelopment programmes with major companies. The restoration of Iranian output constrained by the nuclear sanctions now lifted also pushed Brent and WTI down several times into the $20s in the first two months of 2016. On Friday, Brent closed at $35.10 and WTI at $32.78.

Iran refuses to participate in any output freeze, and a ranking Iraqi Opec delegate last week told this writer that it would continue to expand under its service agreements with companies and budgetary pressures to pay for the rollback of ISIL, despite anything which might be said to the contrary.

In this context it makes sense for Saudi Arabia not to pour more oil on troubled waters. It has in fact been silently pursuing a freeze on production for some months now. The Opec Monthly Oil Market Report estimated the January output of the kingdom at 10.1 million bpd, exactly the same as its average for the whole of 2015.

Some analysts have observed that higher Saudi domestic use of crude to generate electricity would translate to a reduction in exports during the summer, but there is debate whether stored crude and new natural-gas sources would keep oil exports the same.

This will be an important crossover year for the world oil market. The Vienna Secretariat of the 13-member producer organisation reckons that the call on Opec oil will rise from 29.8 million bpd in 2015 to 31.6 million bpd in 2016.

Non-Opec supply is forecast to switch from an increase of 1.3 million bpd last year to a fall of 0.7 million bpd in 2016, a decline still well below 1 per cent in the context of the 94 million bpd world oil market.

January’s rate of Opec production was still 0.7 million bpd above the secretariat average demand forecast for the whole year.

With volumes still being added by Iran and Iraq, and Nig­eria attempting to restore its shale-battered light production, there remains a rocky road for oil prices, especially in the first half of the year.

But non-Opec production might drop more than pre­dicted. Colombian heavy oil has been shut in by a shift in Chinese refineries to discounted Nigerian barrels, from which they get higher-value product yields.

Canadian oil sands producers have in some cases actually been paying refiners to take their crude away during the recent very low oil prices – just to sustain operations. There is a limit to which this grasping at uneconomic straws can last before the victim drowns in debt.

What is now clearer than ever is that they will not be rescued by Mr Al Naimi because the kingdom is completely out of the price stabilisation business. So the future is one of fluctuating prices, and any extra barrels lost by high-cost producers will be permanently replaced by some Opec country.

Ironically price uncertainty is better for Opec than the previous stabilisation policy, according to Geoff Cumming, the founding chairman who sold the Alberta heavy oil production of Western Oil Sands to Marathon a decade ago for $7 billion, assets which are worth a fraction of that today.

“The last thing Opec wants is stable prices because bankers and equity markets place a premium value on predictable cash flows and will fund non-Opec projects,” Mr Cumming told me.

It seems that Arabian Gulf producers have gradually transitioned to a similar view, with price being left to the market and the tooth and claw forces of raw competition.

High-cost producers like Alberta seem destined for long-term pain. “Calgary is not a pretty place any more,” the former oilman said. “There is blood in the streets and Canada’s biggest industry is struggling to survive.”

Jim Crawford is the managing director at Sharjah-based Inter Emirates General Trading Company.

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