posted on 10 February 2016
-- this post authored by Matthew Bey
Oil prices hit new lows in January, but the world's biggest producers still can't seem to agree on how to respond. Venezuelan Oil Minister Eulogio del Pino returned home empty-handed after concluding on Feb. 7 a week of visits to major oil-exporting countries. His aim was to organize an emergency meeting between OPEC members and non-OPEC states. The topic they would have discussed, had del Pino been successful, would have been how to coordinate a cut in global oil production.
But his failure shows that a bloc of OPEC's key Gulf members - namely Saudi Arabia, Kuwait, Qatar and the United Arab Emirates - is resisting the pleas of other producers to intervene in the market on their behalf.
Since November 2014, Saudi Arabia and its allies have made it clear that they prefer to let the market correct itself. In the meantime, they are not willing to unilaterally slash production without other important producers, including Russia, Iran and Iraq, agreeing to do so as well. Of course, pragmatic cooperation among the world's oil exporters becomes more appealing as oil prices sink and financial crises deepen. However, a substantial production agreement - and one that is actually enforced - will probably remain elusive as geopolitical impediments and fundamental disputes among Saudi Arabia, its allies and other oil-producing countries persist. And with no cohesive bloc at its helm, the global oil market will be at the mercy of market forces, promising further price volatility and uncertainty.
A Consistent Strategy, but a Painful One
When most people think of OPEC, they remember the bloc's leading role in the 1973 Arab Oil Embargo and the resulting spike in oil prices. But in reality, Saudi Arabia and its Gulf allies have lost much of the hold they once had over the global oil market; they are now more stewards than puppeteers. In light of its declining influence, Saudi Arabia has responded to market fluctuations since the 1970s in two primary ways.
First, Riyadh has used its spare production capacity to supplement the global supply in times of unanticipated oil shocks. For example, it famously worked to replace lost volumes from both Kuwait and Iraq during the first few months of the Gulf War in the early 1990s, reinforcing its relationship with the United States in the process. When oil prices fall, though, and supply cuts are needed to drive prices back up, Saudi Arabia usually turns to a different tactic: coordinating with as many other producers as possible rather than single-handedly slashing its own output. Since the mid-1980s, four major oil price shocks have occurred, and Riyadh reacted to the first three in this way. When prices declined by over 30 percent during the Asian financial crisis of 1997 and after 9/11, OPEC members, along with Norway, Russia and Mexico, were able to work together to decrease production. After prices collapsed again during the global economic crisis of 2008-2009, OPEC countries organized record-high output cuts.
But the underlying cause of today's low oil prices is fundamentally different than that of the previous three price drops, which were rooted in poor global economic conditions and recessions in key oil-importing regions. By comparison, the latest dip has been driven by the structural shift taking place within the world's supply as North American shale resources have come online and rapid production growth remains possible should higher prices return. As a result, oil producers have been unable to reach a consensus on how best to respond to the latest decline in prices.
For some, including Saudi Arabia, Kuwait, Qatar and the United Arab Emirates, the best option is to weather the immediate pain of low prices and wait for higher-cost producers to succumb to the market. From the perspective of these countries, which have the financial buffers in place to make up for low oil revenues, it is better to slowly bleed North American producers dry and wait for the region's output to drop, bringing the market back into balance. Of course, with most North American shale producers' breakeven costs between $40 and $70 per barrel, the only way for other producers to wait them out is to keep pumping oil and hope that the market reacts as strongly as they need it to. (Indeed, in January, Saudi Arabia's oil rig count hovered at near-record highs.)
Even so, this strategy is not a quick one. Despite ongoing financial stress, North American producers have been relatively resilient so far, and the region's output has hovered at around 9.2 million barrels per day since October 2015. Part of this is because rising efficiency and declining service costs have caused drilling and completion expenses to drop significantly, enabling U.S. producers to cut their capital expenditures without seeing a dramatic decline in production volumes. (Some are even expecting to see production rise in 2016.) Yet OPEC's Gulf producers have been quick to point out that their strategy is working, pegging 2017 as a reasonable time frame by which their efforts will start to bear fruit. Regardless of their optimism, though, Saudi Arabia and its allies will need to see tangible proof that North American production is flagging if they are to become more open to making small cuts in output to hasten the recovery of oil prices.
The problem, as many Gulf producers have noted, is that any reduction in output that is strong enough to push prices back up to somewhere around $70 per barrel would also effectively subsidize the very North American producers that they want to choke off. This would likely enable the United States to keep ramping up its own flows, potentially even forcing Gulf producers to lower their output levels further until physical and technological constraints halt U.S. production growth at higher prices. Even then, with North American shale production still in its infancy, no one can reliably estimate to what production level these constraints would limit North American producers.
Different Producers Have Different Pain Tolerances
While OPEC's Gulf producers are content to batten down the hatches for now, most of the world's other oil producers are not in the financial position to follow suit. Low oil prices have brought immediate and severe political consequences for many governments that rely heavily on oil revenues, making them far more willing to cooperate to alleviate such pain in the short term. Among them, Venezuela has been perhaps the hardest hit. It comes as no surprise, then, that for the past two years Caracas has been leading the charge within OPEC to reduce the bloc's total oil production. Russia, Ecuador, Nigeria, Iraq, Algeria and others are facing similar financial predicaments and have shown varying amounts of interest in coordinating between OPEC and non-OPEC countries to stem oil flows.
Still, their openness to finding a joint solution does not necessarily mean an agreement is on the horizon. In fact, the many stumbling blocks standing in the way of cooperation will, in all likelihood, continue to prevent a deal from being reached. While the mainstream media has made much of OPEC's attempts to protect its share of the global oil market from shale producers, the more important contest underway is between Saudi Arabia and other major oil producers. When Riyadh looks at the world, its sees expanding output in Iraq, renewed production in Iran, and rerouted flows from Russia encroaching on its most important consumer markets.
Over the past decade, the cornerstone of Moscow's evolving energy strategy has been to diversify its oil and natural gas exports beyond Europe. With the Eastern Siberia-Pacific Ocean pipeline now fully operational, Saudi Arabia has had to compete with Russia for the Chinese market and its position as Beijing's biggest supplier. While Russian Energy Minister Alexander Novak has signaled Moscow's interest in working with OPEC, Rosneft chief Igor Sechin is firmly against the idea and would likely try to circumvent any agreed-to quota - possibly by sending supplies to China.
However, the difficulty of enforcing shared production cuts - especially those that would have to be in place for a long period of time - has left Saudi Arabia itself skeptical of coordinating with other oil producers. For instance, after Russia agreed to reduce its output alongside OPEC in late 2001, it abandoned the deal only six months later. This problem is not only confined to working with non-OPEC producers, either; as Saudi Arabia is keenly aware, it is also impossible to enforce production quotas within OPEC itself.
Amid growing Russian encroachment in the Asian market, Saudi Arabia is also seeing its long-time rival, Iran, preparing to ramp up its exports to - and involvement in - both Europe and Asia. Tehran is already in the process of finalizing a 160,000 bpd export contract with France's Total, and it is reportedly doing the same with Italy's Saras and Eni firms. Saudi Arabia will likely be unwilling to reduce its own output unless Iran agrees to do the same. But Tehran has argued that any cuts it agrees to will come from planned production increases or capacity - not from its current output, which in its view has already been artificially constrained by Western sanctions.
And so, Saudi Arabia, Iran and Russia - the three producers that are collectively responsible for about one-fourth of the world's petroleum liquids supply - remain at odds over how to respond to low oil prices. Since Riyadh has little reason to change its strategy for contending with rising North American production, at least for now, Saudi officials are unlikely to lessen their demands that Iran and Russia participate in any proposed reduction in oil output. In the absence of coordinated action, the market will continue to be the dominant force shaping oil prices - something that bodes ill for oil producers around the globe.
With Volatility Comes Instability
The decision to let the market rebalance itself will carry a high price tag. For one, oil exporters that are already strapped for cash, such as Venezuela, Iraq and Nigeria, will find themselves in even more dire financial straits as oil prices stay lower for longer periods of time.
However, we will also see the market become more volatile. Private oil producers respond to changes in the market in ways that organizations like OPEC cannot. Like most commodities, oil and natural gas call for capital-intensive projects that have long production lifetimes and low operating costs. Since private companies usually do not halt production unless prices fall below operating costs, their wells are rarely shut down, even as prices have collapsed. (Even in the most expensive fields, operating costs almost never surpass $30 per barrel.)
But just as changes in the market are slow to take oil supplies offline, they are quick to delay investments in future projects. As low oil prices deal a heavy blow to companies' budgets, the expensive ventures that would come online for years are usually the first to be canceled. When this happens on a wide scale, it essentially guarantees that large volumes of oil will come offline at some point down the road. When they do, it will undoubtedly cause a spike in prices as producers struggle to meet demand.
Thus, the natural forces of the market will lead to more extreme price swings in both directions unless someone, be it OPEC or another organization, steps in to restore the balance. Given the fact that oil is the sole source of export revenues for many countries, political stability in those states will undoubtedly rise and fall alongside oil prices.
The fear of such instability, combined with the geopolitical importance of oil, has long inspired many different organizations to explore ways to steady and control the oil market. OPEC was hardly the first; it arose three decades after the Texas Railroad Commission had begun to implement quotas for oil production in the Lone Star State. Nor is this the first time OPEC's internal rivalries have forced the bloc to abandon its goal of instilling balance within the market. However, the scale of rising North American oil production and its continued potential growth has made it impossible for Riyadh, Moscow, Abu Dhabi or even Austin, Texas, to control and balance the global oil market like once before.
The result is major uncertainty when looking ahead to what is next for the global oil market. Unpredictable fluctuations and varying degrees of pain felt by oil producers will make it far more difficult for a political consensus to emerge on cutting output. Until certainty returns or the shale production growth story has been written, Saudi Arabia and others will have little choice but to protect their own market share and let everyone else deal with the consequences.
"Amid Low Oil Prices, OPEC's Divisions Deepen" is republished with permission of Stratfor.
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