Crude oil — routed since June 2014 from $115 to less than $50 a barrel until recently — found much respite over the past fortnight. Prices shot up sharply; the benchmark Brent, used widely in Europe and Asia, has gained nearly 20 per cent since November 29 from about $46 to $55 a barrel — an 18-month high. WTI, popular in the Americas, has also seen a similar rise.
The rally has been sparked by agreements among major oil producers to cut output and support prices. First, there was a breakthrough in the crucial meeting of the OPEC (Organisation of Petroleum Exporting Countries) on November 30. The cartel, led by Saudi Arabia, the world’s largest oil producer, agreed to cut production by 1.2 million barrels a day. Next, on December 9, 11 non-OPEC countries including mega producer Russia agreed to join hands with OPEC and cut output by about 0.6 million barrels a day.
These agreed cuts, totalling about 1.8 million barrels a day, account for nearly 2 per cent of global oil output. They are to be implemented initially for six months, from January 2017, and could be continued. This should help ease the global oversupply that had contributed to oil prices falling off the cliff over the past two-and-a-half years.
Together, these OPEC and non-OPEC producers account for about 60 per cent of the world’s crude oil supplies. This is the first deal by OPEC to cut output since 2008, and the first between OPEC and non-OPEC producers since 2001. Among OPEC countries, Saudi Arabia will take the largest cut (nearly 0.5 million barrels a day). Russia will cut about 0.3 million barrels a day, the most among the non-OPEC nations.
Strategy shift
Saudi Arabia has, in fact, signalled its readiness to cut more than it has agreed on. This could take its output to below the psychologically important level of 10 million barrels a day. And it marks a shift in the Saudi strategy in its high-stakes standoff with US shale oil producers.
The sharp rise in shale oil output in the US, aided by technologies such as hydraulic fracking, was a key reason for oversupply in the crude oil market since 2014. Rapid growth in its domestic output in the country, among the largest consumers of oil, saw its imports plummet and helped turn it into an exporter.
The OPEC, dominated by Saudi Arabia, responded not by cutting output to support oil prices, but instead by maintaining and even increasing production levels. This exacerbated the crude oil fall. The Saudi strategy was to maintain market share through low prices, while making it unviable for US shale oil producers to continue in business. To an extent, the strategy worked, with some US producers being laid low. But others continued to drill, aided by technological improvements that lowered their cost of production. In effect, the US shale oil industry is still holding up despite the strain, a sign that the Saudi strategy was not yielding the desired results.
Meanwhile, low prices not only hurt US shale oil producers but also put heavy financial stress on OPEC members such as Venezuela and Saudi Arabia itself (despite its deep pockets). With pressure building up within OPEC for higher prices, the Saudis, after holding out for more than two years, decided to change tack from a low-price-higher-volume strategy to a better-price-lower-volume approach. The Russians, too, under financial strain from Western sanctions, seem to have decided in favour of better prices. Both Saudi Arabia and Russia depend primarily on oil export revenue.
The Trump factor
The change in the Saudi approach could also have been accelerated by the election of Donald Trump as the next US President. Under Trump, the US shale oil sector is set for a boost. Trump’s ‘America First’ worldview and his pro-business leanings will likely make things easier for US shale oil and gas producers through financial incentives, tax breaks and easier land and environmental clearances.
This could lower their cost of production and help them compete, even at lower prices, against the traditional producers. Over the past few years, shale has helped the US secure energy independence and added to its geopolitical heft. The US is unlikely to let go of this advantage, given the evolving dynamics in West Asia.
So, the Saudi strategy change may have been prompted by a realisation of the financial and geo-political challenges in sustaining and winning the low-price game.
Difficult deal
Still, the recent deals to cut oil output have been tough to sew up and could be even tougher to implement. Iraq has agreed to cut production. But Iran, the other big producer in OPEC and a long-term Saudi Arabia adversary, has been allowed to raise output given its post-sanctions status. This would have been hard for the Saudis to digest. Others, such as Libya and Nigeria, have been exempt from output cuts due to the disturbances there. Indonesia refused to cut output and opted out of OPEC.
Also, while agreeing to deals is fine, what will really matter is compliance. There have been instances in the past of oil producers not keeping their word and deals falling through. The temptation to increase oil production will grow with a rise in prices. So, without output discipline, prices could again fall.
Price cap
Even if the deals are sustained, the cuts are implemented in spirit and oil prices do rise, there will likely be a cap around $60 a barrel. At this level, many US shale oil producers, lying low for the time being, could find it viable to make a comeback. Incentives by the Trump administration could act as a sweetener. Major producers such as the US, Brazil, China and Canada are not part of the recent deals to cut output. A rise in output in these countries could cap oil prices.