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reflections

Dec 3, 2015 | 23:49 GMT

The Saudis Change Their Tune on Oil Production Cuts

(Stratfor)
It can be difficult to separate the important from unimportant on any given day. Reflections mean to do exactly that — by thinking about what happened today, we can consider what might happen tomorrow.

Ahead of the Dec. 4 OPEC meeting in Vienna, an unnamed delegate said Saudi Arabia is organizing a cut in global oil production in conjunction with OPEC and non-OPEC countries. Although Saudi officials have denied the claim — and the report of the claim even noted that an agreement is unlikely to materialize at the meeting — there has been a subtle shift in the Saudi kingdom's tone on its oil policy.

According to the leaked plan, Riyadh would call for an oil production cut of 1 million barrels per day with three requirements. First, the cut would need to include countries outside of OPEC, such as Mexico, Russia, Oman and Kazakhstan. Second, Iraq would need to freeze production at its current level (around 4.3 million bpd). Third, Iran would need to participate in the production cut.

This plan would seem like an optimal one for Saudi Arabia, and it is not an entirely new idea for Riyadh; the Saudis have been consistent in their position that they would let the market do what it pleases and would only partake in a production cut if everyone in OPEC, not just Saudi Arabia, did so. The big change over the past few months is that Saudi Arabia's rhetoric seems to suggest that Riyadh is more open to the idea and could be on the verge of trying to take a more proactive position in organizing a production cut during the next year or two.

Next year could be an optimal time for Saudi Arabia, or all of OPEC, to change its position. Oil prices are hovering around $40 per barrel, and the average oil price in the OPEC basket is $38.50. This is well below the price needed to make investment into more expensive sources of production, such as shale oil and tight oil in North America, attractive. The breakeven cost for developing U.S. shale and condensate resources varies considerably from basin to basin, but at around $65 per barrel these resources become much more attractive. The current low oil prices mean that U.S. oil production is on the retreat and could fall from its peak of 9.6 million bpd, reached earlier this year, to somewhere around 8.75 million bpd by the middle of 2016.

At the same time, 2016 is a new year, which means that many oil price hedges that North American oil companies took out before oil prices collapsed for the 2015 fiscal year will expire. For example, about one-fifth of U.S. production fetched an average price of $80 to $85 per barrel in 2015 because of these hedges, putting the countries that took those hedges out in a better financial position. The amount of production hedged for next year is about half that of last year, and the price is closer to $60. Additionally, some U.S. companies are beginning to experience limited access to credit. Although these limitations are not ubiquitous, the U.S. energy sector largely is not in the financial position to react quickly to a moderate rise in oil prices (such as one toward $60 per barrel). In short, it will take oil prices well beyond $40 to stabilize that decline. 

In a sense, Saudi Arabia is attempting to see whether the strategy of letting prices fall to weed out expensive producers has run its course and now is the time to drop production slowly, allowing prices to recover moderately. Of course, Saudi Arabia does not want to do this alone and would be open to coordinating such a policy.

But doing so is not easy. Saudi Arabia knows very well that many OPEC members, such as Algeria, Nigeria, Venezuela and Libya, are under more financial strain than Riyadh is and that they cannot implement anything beyond token cuts in oil production. Beyond that, physically implementing cuts in places such as Nigeria — where international oil companies operate almost all production — is extremely difficult, if not impossible. This has always been one of the challenges within OPEC: Realistically, only Saudi Arabia and its Gulf brethren can cut production by a significant amount — and that bloc is also the part of OPEC least susceptible to low oil prices.

Iran has already responded to the leaked proposal and made it clear that it will not voluntarily cut production. Moreover, the Iranians said no one can tell them not to export more oil when international sanctions are relaxed next year. Riyadh is perfectly content to slow down its oil production to raise prices, but only if Tehran follows suit; the Saudis do not want to cut output only to see their old geopolitical rivals, the Iranians, increase production and reap the benefits while counteracting the price effects of the Saudi cut.

This may render the conversation between Riyadh and Tehran a non-starter and a change of tune within OPEC premature. The Saudis are capable of coping without a production cut; Riyadh has continued to prepare for an extended period of prices well below the $100 per barrel price that it needs to balance its 2015 federal budget. For example, Saudi Arabia is beginning to issue bonds and is considering substantial budget cuts and social spending reforms. The Saudis will not cut their budget by the amount needed for the current oil price to balance it. Instead, they will continue to slowly adjust spending in preparation for a long period of moderate oil prices.

Of course, if the Saudis ever organize an announced production cut, the question will be whether the cut materializes, whether it is sustainable and, most important, whether it has its desired impact. If OPEC cuts production by 1 million bpd, it would send OPEC's overall production from the current 33.1 million bpd to roughly what the cartel produced in the first quarter of 2015. It would not lead to a dramatic uptick in prices, but it would signal a start toward a recovery that could eventually see prices approach the point at which most U.S. shale production becomes economical.

Although the leaked proposal by Riyadh may not be entirely real, Saudi Arabia is definitely moving away from what has been a rock-solid policy of maintaining high production since last December's OPEC meeting. Given Iran's likely increase in exports in the first half of 2016, an agreement at the Dec. 4 OPEC meeting is probably premature. However, the groundwork that Saudi Arabia is laying could form the basis for action on the issue later in 2016. 

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