November 18, 2016
Saudi Arabia is already lobbying hard ahead of the cartel’s November meeting for OPEC to cut oil production to durably boost crude prices. A deal that will prop up oil prices is particularly important for Saudi Arabia. Low prices have left the country with a 15% budget deficit (2015), have made it more difficult to sustain oil exploration investments, and will disadvantage the sale of a 5% stake of Aramco on international markets next year. Despite uncertain prospect for success, Saudi Arabia continues to press its counterparts, calling a deal “imperative.”
Last month in Algiers, OPEC members agreed in principle to limit production to 32.5 to 33 mb/d to boost prices. They also committed to reaching a full-fledged agreement with firm limit targets and a cut in allocation by November 30th.
As expected, the main OPEC producers have been angling for the least painful possible cuts. For starters, they have pushed production to record highs, reaching 33.8 bb/d at the end of October. This is designed to establish the highest possible baseline for future cuts, thus resulting in the least possible negative impact on the producers’ budgets. Several producers have also claimed inflated production capacities. Iraq claims it is producing 4.7 mb/d and not 4.2 as OPEC says. Iran has offered to freeze production at 4.2 mb/d while its actual output is 3.6 mb/d with little spare capacity. Both Iran and Russia argue they can boost production. Finally, Nigeria and Libya are still arguing for exemptions saying they need to restore production levels hurt by conflicts.
So what is ahead? The Algiers agreement precipitated a price rally up to $52 per barrel. But as a deal remains elusive, prices have fallen back. Here are four potential outcomes from the upcoming meeting:
- The Freeze Deal (most likely): There is no agreement to cut back, but producers agree to freeze at the highest output levels of October, paving the way for a very gradual rebalancing of supply and demand and a price stabilization. Confidence in OPEC’s relevance and Saudi Arabia’s leadership role is reaffirmed as they manage to follow through on their September commitment. In the short-term, the economic stress on KSA continues as prices only move up slowly. Budget tightening and spending cuts are still on the agenda. The Saudis will use the prospect for market stabilization to boost Aramco’s prospects ahead of the sale. However, as producers have nearly maximized production, their spare production capacity is reduced. In the long-term, this has two damaging ramifications. First, the ability to use spare capacity to smooth over market ups and downs diminishes. Second, producing at maximum levels delays badly needed maintenance. OPEC and Saudi Arabia have invested a lot of diplomatic capital in making sure a deal happens and a freeze is not as painful as cuts.
- The Fake Deal (somewhat likely): All parties agree in public to a deal, but in practice it does not hold as everyone cheats to avoid the pain of the cuts. In theory, a common agreement is good for the collective group as long as all members abide by it. But because each party cannot be sure the other parties are implementing in good faith, there is a strong incentive to cheat. In that case, oil production continues to slowly rise and prices cannot recover. Cost pressures keep unconventional oil on the sidelines. Confidence in OPEC and Saudi Arabia to move the market declines. OPEC members blame each other for betraying the cartel’s objectives with accusations and counter-accusations. Blocks form with Saudi Arabia and the smaller producers (Algeria, Nigeria, Libya) on one hand, and Iraq/Iran on the other. Non-OPEC members have little incentive to negotiate with the cartel. Fiscal pressures continue to build on Saudi Arabia, which must resort to issuing more debt or make additional cuts to social programs, increasing the risks of social tensions. This is not an optimal environment to partially privatize Aramco, and Saudi leaders might consider auctioning off a larger share of the company to compensate for a lower value. The ‘fake deal’ satisfies the members’ need for saving face after all they have invested in negotiating the deal, while leaving them with a way out.
- The Best Deal (less likely): There is a production cut agreement that holds. Particularly if the cuts are significant (1 mb/d or more), there is potential for a rebalancing between supply and demand. As supply tightens, the glut is absorbed, and price hikes compensate for production cuts. A serious deal restores confidence in both OPEC’s ability to manage the market and Saudi Arabia’s leadership role. Tensions among OPEC producers (and Russia if it agrees to be party to a deal) ease up. However, a significant price increase also encourages more producers and more expensive producers (unconventional oil) to return to the market. Challenges to OPEC market-shares stems from the non-OPEC and unconventional oil producers (the US chief among them). Internally, KSA’s budgetary pressures are alleviated and the climate to auction off part of Aramco improves. Ahead of the partial privatization, higher prices enhance Aramco’s investment capacity and its value to potential buyers. Everybody agrees there needs to be a rebalancing in the market, but taking deep cuts is impractical and unpopular for most countries. If there is such an agreement, it is more likely the cuts will be more nominal than substantial.
- The Worst Deal (least likely): The tentative agreement reached in Algiers unravels. KSA fails to convince its partners (particularly Iraq and Iran) to limit their output. Downward pressure on price continues, particularly as demand remains soft. Unconventional oil development remains hamstrung. Should members push to maximize their output at the expenses of their spare capacity, then their ability to manage the market will further diminish and their ability to ensure proper maintenance will have long-term negative consequences. The failure to strike a deal undermines confidence in OPEC’s relevance and damages Saudi Arabia’s reputation as a market maker. Regionally, acrimonious recriminations follow as members accuse each other of failing the organization. Tensions between Saudi Arabia, Iraq, and Iran increase. KSA’s budget deficit remains high and potentially continues to grow if commensurate cuts can’t be made. The new oil leadership team installed by Mohamed bin Salman in 2015 might even experience a backlash. This is an unfavorable environment to partially privatize Aramco. There is no doubt the players know a no-deal outcome would upset markets and have a negative impact on prices. They are keenly aware this would harm their bottom line and will strive to avoid such outcome.
Despite the media hype stemming from the tentative agreement in Algiers, the November meeting may not yield any dramatic upside for OPEC, Saudi Arabia, or Aramco. A significant cut in production is needed to have a lasting uplifting impact on price. Although any price improvement will likely improve the value of Aramco, Arabia’s ability to finance its ambitious economic diversification will remain hampered as capital expenditures will likely take a second seat to more urgent state expenditures.