Thanks Vienna, you’ve been wonderful.
OPEC and a few associates announced on Thursday they would prolong supply cuts, as we knew they would.
OPEC extended its cuts by nine months. It even admitted a new member, Equatorial Guinea, boasting 0.3 percent of global oil production and a ranking of 135th out of 188 on the UN’s Human Development Index. (Yay?)
But if you can look past the fanfare, OPEC’s weaknesses are glaring. And the weakest link could be the one usually regarded as the strongest: Saudi Arabia.
The fact OPEC has roped in frenemy-in-chief Russia to bolster its agreement, and hopes this relationship will become permanent, is the most obvious sign of the organization’s struggles.
Another is the fact that the cuts were merely extended rather than deepened; not exactly the “whatever it takes” approach OPEC has touted. As my colleague Julian Lee wrote here, these cutbacks look feeble compared to previous episodes. OPEC says it will monitor progress and might intervene further, hinting strongly the nine-month timetable is actually open-ended. Oil prices slumped on confirmation of the deal.
It’s possible that promising deeper cuts simply would have led to lower compliance. There are cracks in the ranks. Already, Nigeria and Libya are exempt from the cuts due to civil strife. Iran is also exempt due to earlier sanctions.
OPEC’s economic divisions have widened sharply. While the United Arab Emirates grapples with the thorny problem of financing preparations for hosting the 2022 soccer World Cup, Venezuelans are struggling to feed themselves. This chart shows the highest real oil export earnings per capita for any OPEC member versus the lowest over time:
And here’s how the absolute numbers look for OPEC as a whole and Saudi Arabia:
That difficult-to-see recovery in OPEC’s per-capita revenue reflects the Energy Information Administration’s projections of Brent crude prices rising to average of about $53 per barrel this year and $57 in 2018.
The read-across to Saudi Arabia’s own revenue is not good, especially as it is simultaneously trying to radically reform its economy, find useful jobs for a young, fast-growing population, fight several wars, and launch what would likely be the biggest IPO ever, that of Saudi Arabian Oil Co., or Saudi Aramco.
The continuation of cuts by OPEC & Co. offers support to oil prices over the next year or so. That is useful to Saudi Arabia in terms of mitigating its deficits and, of course, getting a good IPO price for Aramco (the country’s energy minister denied this was a factor in answer to the final question at Thursday’s press conference.)
But what then? As I wrote here, raising prices much above $50 a barrel helps U.S. E&P firms accelerate production. OPEC typically requires roughly three to five quarters of cuts to flip the oil futures curve to a downward slope — so-called “backwardation” — thereby spurring inventories to drain faster, according to Francisco Blanch, a commodity strategist at Bank of America Merrill Lynch. Unfortunately, he adds, that’s also roughly how long it takes for shale frackers to respond.
Previously, a combination of high demand growth and long delays in bringing rival supply onstream meant cuts could in theory deliver several years of high prices to provide a windfall. That doesn’t hold true now; half the oil market, as represented by the OECD countries, already faces secular decline.
A recovery in prices to $83 a barrel — the IMF’s estimate of what’s needed to balance Saudi Arabia’s budget this year — would spur further efforts at demand conservation and, of course, celebrations in Texas (and North Dakota and Alberta). In addition, given Iran’s estimated fiscal breakeven oil price of $51 a barrel, it would strengthen Riyadh’s main adversary disproportionately.
So on its current course, Saudi Arabia can look forward to horse-trading sessions in Vienna with fellow members and, crucially, Russia, as far as the eye can see. And for what? To try to manage oil prices in a narrow range of about $50 to $70 that doesn’t even balance its budget.
What’s more, it is incongruous for Saudi Arabia on one hand to nudge production up and down to influence oil prices and on the other try to maximize the valuation for Aramco as a listed, commercial entity. How exactly are those quarterly guidance updates going to dovetail with Vienna’s biannual festivities?
The only viable long-term strategy Saudi Arabia has is to do what most oil companies have been doing: cut costs.
Saudi Arabia’s operating costs are already very low. Wood Mackenzie puts them at less than $20 a barrel on a weighted-average basis, versus roughly $45 for U.S. shale.
The problem, of course, is that Saudi Arabia’s oil industry is like an efficient rig crew tied to an exceptionally bloated head office. Fixing that means cutting the non-productive state jobs and subsidies that swell the budget on one side and boosting the sources of revenue coming from things other than oil exports, such as tourism.
That is precisely what the reforms championed by Deputy Crown Prince Mohammed bin Salman aim to do. In a recent interview with CNN, the country’s finance minister said that, by 2020, Saudi Arabia might be OK with oil at $40 a barrel.
In a report published in march, Christyan Malek of J.P. Morgan estimated that getting Saudi Arabia’s fiscal breakeven price down to $50 a barrel by 2020 would require roughly doubling non-oil revenue relative to 2016.
So this is ambitious, to say the least. The point, though, is that Saudi Arabia is on the deflation train when it comes to its cost per barrel, just like the E&P sector and (helped by a devalued ruble) Russia. This is another structural shift down in the oil market.
For now, the cuts by OPEC, Russia and others, as shepherded by Saudi Arabia, serve a useful purpose of supporting prices enough to stretch the country’s foreign exchange reserves over more years of deficits while it attempts its reset.
Clearly, though, OPEC’s divisions between haves and have-nots will widen further. At some point, it will not be in Saudi Arabia’s interest to promote policies that raise oil prices to the giddy levels required by some other members. OPEC may not be fully killed off — there’s symbolism to consider here — but its relevance will keep fading.
Within 18 months, Aramco’s IPO could be done. And in Russia, the presidential election will be out of the way and several new oil projects are due to start ramping up production.
Beyond then, Saudi Arabia can choose to focus on cutting costs and maximizing market share — as well as the value of Aramco — as in any normal commodity market. Or it can continue playing roulette with the Russians, technology, and OPEC’s stragglers.
This won’t be its last Viennese waltz, but that day is coming.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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OPEC’s Weakest Link Is Not Who You Think It Is – Bloomberg