The oil industry is guardedly recovering from a two-year slump, with investments in new development projects being cautiously reconsidered. Yet, doubt is still clouding the success of OPEC’s latest deal even after a not-seen-before level of commitment. However, OPEC is not the main market manipulator it once was. The fate of the cartel itself or any future role does hang on the success of this cut. The latter depends on one party; Saudi Arabia.
History proves that the oil price is greatly determined by geopolitical events or manipulations. The 1973 Arab Oil Embargo was shortly followed by a supply disruption from the 1979 Iranian revolution. Realizing that supply cuts lead to quick proﬁts, OPEC curtailed the ﬂow of oil, leading the 1980s to become a period of economic slowdown in the US, Europe, and Japan, the three main demand markets. The price slumped from $27 to $10 by 1986. At that point, OPEC promptly set a quota to salvage the price.
A decade of high oil prices starting 2004 to 2014 brought huge liquidity to the coﬀers of oil-producing countries. An exception was 2008–2009 when demand collapsed due to the sub-prime mortgage economic crisis. Even at that point, OPEC intervened to reduce the exposure of member economies by upholding a cut. The current oil climate is analogous to both events; it features interlinking supply and demand disruptions. In June 2014, the price was as high as $115 then lowered to $35 in February 2016.
High prices made it commercially feasible for non-OPEC producers to achieve comfortable proﬁt margins. Notably, the shale revolution in the United States that diverted almost 4.3million barrels per day of previously imported foreign oil to the global market. This was further expanded by increased production from Canada, Russia, Brazil and smaller players. Even within OPEC itself, additional ﬂow came from Saudi, Iraq and GCC states replacing dwindling Iranian supplies under sanctions. On the demand side, a downtrend in the growth of emerging economies, especially in China, the world’s factory caused a decline in the consumption of oil.
OPEC Woes & A Saudi Change of Heart
Following its track record of protectionism, OPEC introduced a production cut, it was the ﬁrst since 2008. The deal came to materialization after months of disagreements between leading member countries. Most noticeably Iran and Saudi Arabia, the regional rivals of the Middle East. This signaled a shift in the kingdom’s approach to oil prices, from promoting a free market attitude under oil minister Ali Al Nuaimi to prioritizing oil revenue security as demonstrated by Khalid Al Falih’s softer stance. This power transition was a last resort after attempts at cutting bloated government expenditure, public wages, infrastructure projects, subsidies, and handouts. However, this change may as well reveal a deeper momentum in Riyadh where a younger and bolder leadership has emerged under Deputy Crown Prince Mohammed bin Salman, the son of the current king of Saudi Arabia, and the third in line to the throne.
The Prince’s ambitious plan to transform the economy away from oil reliance to diversiﬁcation is outlined in ‘vision 2030’. Most importantly, oﬀering 10% of Aramco for an IPO. The Saudis may indeed be writing the playbook for other petroleum reliant nations, but such a daring decision must guarantee the highest capital as the proposed investment fund is to be built utilizing the oﬀering’s earnings. For that to be achieved, Saudi cannot proceed in a $40 or less climate. Not to mention, the Saudis have been burning through their monetary reserves to ﬁnance their mammoth budget and its associated deﬁcit. Oﬀering the ﬁrst ever dollar-denominated bonds in October 2016 allowed the kingdom to snatch $17.5 billion from investors. With attractive rates, good ratings, a large economy and virtually little to no debt, Riyadh is expected to tap into another $120 billion in the years to come. According to the Financial Times, today’s 8% debt to GDP is expected to grow to 30% by 2020. The government claims that these inﬂows will fund the transition ‘Vision 2030’ promotes. Yet, skeptics fear that this capital might be a victim of the past times of excess rather.
Saudi’s drivers for a deal fell in line with those of the other members of OPEC. An attempt to kick-start a production cut was initiated by Venezuela many months before the meeting in Algiers. Suﬀering an economic catastrophe after the oil collapse, the Bolivarian republic’s inﬂation rate jumped to 700% last year. As of this morning, data published by the central bank shows them burning through their last $10.5 billion in foreign reserves. Caracas might stand as the ultimate worst case within OPEC one might argue. After all, the economy was mismanaged long before the crisis. Yet, if modestly populated GCC members of OPEC are set aside, the rest of the cartel are not safely behind. Iraq, a country that trumps other nations in levels of corruption and mismanagement, is ﬁghting a ﬁerce and expensive war against ISIS. Iran has hardly emerged from sanctions to face an unfriendly new administration in the white house. Libya is struggling to start oil exports as three or more governments are competing for international recognition. Nigeria’s oil and gas sector still suﬀers from the stigma of being exposed to terrorist attacks while the rest of the members are not progressing on economic reform and transparency.
Conventional Oil’s Dilemma & Shale’s Triumph
The challenge to global oil production is colossal. Naturally, oil ﬁelds mature and decline in output, the IEA estimates that the world loses the equivalent of the current production of Iraq every two years. This has been the stimulus for investment in exploring and developing new ﬁelds. However, in the past two years, the number of projects receiving approval has been the lowest since the 1950s. Shale oil production is characteristic of withstanding price disruptions due to the short investment cycle where wells are drilled almost immediately within known formations in huge numbers and independently then abandoned once maximum volume capacity has been exploited. Conventional oil cycle is longer, complex and involves multiple stakeholders. Generally, it takes 3 to 6 years from the point of investment to producing ﬁrst oil. Hence, shale oil has shown remarkable reliance on the price drop.
OPEC has claimed that its move is in good faith for both producers and consumers. It argued that the low oil price is hindering company investments and will reﬂect in the long term as a shock to market stability. The IEA and OPEC are aligned on this conclusion, the former foresees inability of supply to match with increasing demand in the early 2020s resulting in the emergence of a boom and bust cycle. Another threat to supply comes from OPEC’s spare capacity being limited to about 2 mbpd almost completely located in Saudi Arabia.
Post their meeting in Algeria, OPEC and Non-members held several high-level meetings that resulted in the Vienna Accord. A reduction of 1.2 million barrels per day was agreed upon from the total daily OPEC production of 32.5 million barrels per day. An additional 0.6 million barrels per day are to be contributed from 11 non-members. With Russia promising to carry half of the non-OPEC reduction. The duration was set for six months, to be extended in accordance with the prevailing conditions of the market. In other words, whether to continue with the deal or not will largely depend on how eﬀective is the cut to the oil price in the ﬁrst place.
Fearing oil production overestimation by members, OPEC did not use a single source of data but six secondary sources for conﬁrmation including loading data from tankers. Iran, Libya, and Nigeria were spared from the cut. The Saudi reluctance to proceed without an Iranian inclusion was undone with the participation of Russia, after all, the Kingdom did not want to carry the most burden of reduction by itself then lose market to competitors. The cut was distributed in a 4–5% discount from current production levels of all other members. Saudi Arabia carried 486 kbpd while Iraq, UAE, and Kuwait covered 210, 139 and 131 kbpd respectively.
Compliance & Enforcement
Since the introduction of the cuts, the oil price has gained an increase of 20%. Data published by OPEC showcased a high compliance by members at 90% (93% according to Bloomberg). So far, the deal has been honored within the cartel better than any previous one. This level of compliance has been supported by data published by the IEA too. The agency has conﬁrmed that OPEC has slashed its production by 3% to 32.1 mbpd. Indeed, this is one of the deepest cuts in the history of OPEC.
Saudi has always taken the role of the lead producer and enforcer within OPEC. Their share of the cut has increased to 560 kbpd. This is 16% above their commitment. Such an action is not abnormal but is representative of previous deals. There are diﬀerent reasons to justify this higher compliance. the kingdom wishes to oﬀset additional production coming from non-participating members like Nigeria and Libya. Also, to ensure a minimal eﬀect on future exports as it has the space to maneuver while its domestic oil consumption is at its lowest. Logically, Saudi makes money from oil exports, not internal sales that are known to be highly subsidized. Historically, when faced with criticism on below commitment production, oil ministers in Riyadh answered that their average production should be taken into consideration rather than month by month basis. While Iraq and UAE have started to decrease exports, their commitment is still lesser than that of Saudi, Kuwait, and Qatar. On the other hand, data from the IEA shows that Russia is gradually reaching its target with a 100 kbpd drop in January.
Inventories & Outside Players
Many believe that the success of the deal depends on how fast can the supply crunch drain inventories. Recent data from the EIA shows domestic commercial crude, excluding oil held in the US SPR (Strategic Petroleum Reserve), totaled 518.1 million barrels after an addition of 9.5 million barrels just by end of February 10. This weekly increase is a record level since 1982. In July 2016, OECD stocks reached an all-time high of 3.1 billion barrels of crude and reﬁned products. Latest Oil Market Report by IEA shows them down to approximately 2.9. Demand has indeed outpaced supply, in December 2016, these stocks drained at 800 kbpd. Estimates show that they will continue to do so at 600 kbpd. However, there is also a possibility that inventories have actually reached a sustainable balance with supply. On the other hand, neither the IEA or other international organization possess veriﬁed knowledge of Chinese oil storage volume.
Production from US, Brazil, Canada and non-participating parties is forecasted to surge by 750 kbpd in 2017 then narrowing down to 400 kbpd if non-OPEC members stick to their obligations. Recent drilling activities in the US are forecasted to add 175 kbpd ending 2017 with 520 kbpd higher on year to year basis. US Shale basins have taken breakeven price well below $50 with lower costs and streamlined extraction technologies. The US shale patch is undergoing a reallocation of stakes; majors are entering to collect as much proﬁt as possible on account of smaller producers. Independents have amassed large amounts of debts resulting in a loss of conﬁdence that brought investment down by 52%. On the other end, larger US oil companies have posted the least proﬁts in decades, their debts have reached high levels with majors like Exxon borrowing to cover dividends. Nonetheless, their internal cash ﬂows can allow them to venture into Shale patches and collect quick revenues. Exxon has declared their intent to develop 6 billion barrels of Shale oil in West Texas and New Mexico.
The Fate of OPEC
A year ago, analysts were debating if OPEC mattered anymore as US Shale stood strong with lower breakeven prices. Two months into the cut, the deal has helped the oil price reach the mid-$50s level. Playing a lesser role in times of oversupply is not new to the cartel, but the period they waited before supporting prices was longer this time. Furthermore, this is not the ﬁrst time they coordinate with non- members. In 2002, Mexico, Norway, and Russia joined OPEC in price maintenance eﬀorts. Even in the 2008 reduction of 4 mbpd, Russia symbolically participated.
The key question today is how will this deal reﬂect on the future of the cartel? The IEA predicts that OPEC’s share of the market shrinks in the early 2020s pushing it towards a policy of market management to claim 50% share by 2040. Although this deal was driven by fears of near-term economic harm, it stands as a vital factor for such a projection. Still, OPEC’s future will always be shaped by Saudi’s economic and political policy as a swing producer. Eﬀectively thus far, this deal is more than 50% on Saudi’s shoulders. Any forthcoming role for the organization will be determined by the Saudis. However, if the deal fails, it will be the ﬁnal blow to OPEC’s desires for relevance or any form of unity, even if artiﬁcial.
The applications of oil in the future will immensely diﬀer. The recent innovations in electric vehicles and technological advances in both battery and fuel eﬃciency technologies suggest that the volume of oil being used at transportation has either peaked or is on the pathway to reduction. This is part of a broader energy transition where cleaner energy and less polluting natural gas have a leading share of growth and energy investments. Oil producers will have to focus on alternative sectors where oil is invaluable. Petrochemicals, freight, and aviation. Also, emerging and developing regions of the world where growth in future oil consumption persists. Whatever hope left for oil-dependent economies of OPEC is a sincere pivot towards diversiﬁcation and transparency. If Venezuela’s dire situation does not ring the alarms, nothing will.