Saudi’s Cheap Oil Strategy Has Failed

“In the absence of a major financial meltdown, oil will end 2016 north of $60 a barrel.” So stated this column at the turn of the year – a forecasting flourish possibly fuelled by one Christmas brandy too many.

Back then, in early January, having plunged all the way from $115 in mid-2014, Brent crude was trading at $37 a barrel. In February, oil fell again, going below $30. At that point, my $60 prediction looked silly.

Since then, though, the black stuff has climbed steadily. Last week, oil surged decisively above $50 and is now showing strong upward momentum. A price of $60 before the end of 2016 now looks within reach.

Part of the reason behind this price rise is the Organization for Petroleum Exporting Countries. And it was the infamous exporters’ cartel, of course, which brought prices down in the first place.

Opec has spent most of its 56-year history limiting oil output in order to keep prices higher than they otherwise would be, so benefitting its members. Back in 2014, though, under the leadership of Saudi Arabia, a decision was made to flood oil markets to bring prices down in a bid to bankrupt the relatively high-cost North American shale oil producers who were eating into Opec’s market share.

Controlling around a third of the world’s oil production, Opec still has huge clout. From 31.8m barrels daily in early 2014, total Opec production has since soared to 35.4m, putting enormous downward pressure on prices.

Now, though, with Saudi and several other Gulf states enduring serious fiscal pain, Opec has done a volte face. For the first time since 2008, the cartel last week agreed to a production cut, pledging to lower joint output by 1.2m barrels.

Having previously pushed members to pump more to “sweat” US shale producers, Saudi has now agreed to take the bulk of the cuts, reducing its own production by 0.5m barrels daily, or almost 5pc. Other Gulf OPEC members – United Arab Emirates, Qatar and Kuwait – say they’ll together cut 0.3m.

Iraq, which had previously argued for higher output quotas to raise money to battle against Islamic State terrorists, has also now agreed to cut its daily production by 0.2m barrels. Iran, in contrast, secured a boost in its quota – in line with Tehran’s argument that, having been excluded from global markets by sanctions for many years, it needs to rebuild market share.

This Opec production deal has been stymied for months by disagreements between Saudi and Iran. Their ancient enmity, encapsulating the split between Sunni and Shia Islam, has lately seen the two countries at loggerheads over respective production limits. Now Riyadh has agreed to big cuts, while Tehran has secured a quota slightly above its current 3.8m-barrel production, allowing Iran to edge towards the 4m-plus it was producing prior to sanctions. This represents a big power-shift, with Saudi ceding ground to its regional rival.

This deal has happened because, with prices having fallen so far, many oil-dependent Opec-members have been enduring serious fiscal pain. While the 14-member states reaped $518bn of oil revenues in 2015, that was a massive 45pc down on the year before. Opec nations recorded a combined current account deficit of $99bn last year, having run a $238bn surplus as recently as 2014, the year the Saudi’s suggested then turning the spigot and waging a price war with the non-Opec world.

Saudi, of course, has suffered the most. Since oil prices collapsed, Riyadh has imposed deep budget cuts but is still running a budget deficit close to 20pc of GDP. The Desert Kingdom, having burned through some $180bn of its financial reserves, around a quarter of the total, is now selling off part of its flagship production facility, Saudi Aramco. Kuwait and UAE have also been feeling the fiscal heat, running budget deficits of 12pc and 9pc of national income respectively.

This Opec deal is eye-catching and historic. Last week’s news caused an instant 10pc spike in the oil price. It’s important, though, not to overstate its impact on actual supply. Yes, oil prices are now likely to rise for a while, and the likelihood of Opec’s price-bashing strategy failing, and a deal ultimately happening, was a major reason why I thought crude would top $60 by the end of 2016.

Understand, though, that production rises in recent months mean that the output levels Opec now says it will now cut to are the same as those in February – when oil hit a $28 low. Remember, too, that many Opec members have a well-earned reputation for “quota-cheating”, pumping beyond agreed limits in a bid to free ride off the higher prices generated by the production discipline shown by others.

The really big fly in the ointment, though, as far as Opec is concerned, is that its supply-restrictions rely on a 600,000 cut in daily production by non-Opec members, with Russia accounting for half of that reduction. Will Russia comply? Moscow says it will but serious question marks remain.

Yes, this Opec deal has overcome huge political hurdles. In both Yeman and Syria, Iran is fighting an effective proxy wars against Saudi Arabia. And now, while standing alongside Iran in both those conflicts, Russia is also agreeing to help Saudi by publicly backing Opec-initiated production cuts for the first time since 2001.

The most glaring conclusion one must draw from this deal is that Saudi is desperate. That’s why Energy Minister Khalid al-Falih said ahead of the meeting that Riyadh was willing to take “a big hit” on production to get a deal done. Moscow, meanwhile, is in a much stronger position – which raises doubts over whether Russia, like the Saudis a 10m-barrel-a-day producer, will keep its word. The history of deals between Moscow and Opec, after all, is littered with Russian non-compliance.

While Russia says is will cut production by 300,000 barrels a day, no-one has agreed the level that cut is from. Also, while Moscow is due to run a budget deficit of 3.2pc in 2017, that estimate rests on a rather low $40 oil price assumption. Often cast as fiscally weak, Russia is actually in a rather strong budget position.

Commanding the world’s third-biggest foreign exchange reserves, the country has extremely low government debt and, in net terms, is a creditor to the rest of the world. If Moscow wants to pump more oil to keep a lid on prices, to hurt Saudi for geo-strategic purposes or for any other reason, then the Kremlin can afford to forego a few oil dollars. Russia is far from fiscally desperate and oil price bulls shouldn’t expect Moscow’s compliance with Opec on that basis.

The main reason why oil prices, while trending upwards, are unlikely now to go sky high, isn’t because this Opec deal, for all the related arm-twisting and political sacrifice, will ultimately only partially hold. The main reason is that oil priced at $50-$70, rather than languishing in the $30-$40 range, will massively benefit shale producers and other relatively high-cost suppliers, bringing back on stream a range of oil sources that simply couldn’t cope when prices were so low.

On US stock markets, the share price of over 50 American exploration-and-production companies climbed by 10pc or more last week. Those gains are partly speculative, of course, by they reflect the reality that many such producers have become more efficient during this Saudi-induced price collapse, their break-even prices now nearer to $50 than $70. It would be rude to point out that Saudi’s cheap oil strategy has failed. But it has.

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