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To cur or not to cut? The OPEC output saga: l'acte ultime

To cur or not to cut? The OPEC output saga: l'acte ultime

Opec’s production cut has been the key news story for the past few months in an oil market torn by uncertainty, abundance and downward pricing. The world was set for anticipation back in September when the OPEC members agreed to agree later how much they would each reduce output by. The reduction per se seemed not to be contested at the time. Exactly two months later tomorrow, Wednesday 30th (and two years after the last OPEC production control meeting which ushered the unprecedented supply glut we witness today), the speculation will end – or so the spectators hope. OPEC ministers are set to agree final output reduction at their meeting in Vienna tomorrow. But would they? The lingering optimism of September seems to have slowly evaporated.

What is at stake? Structural market reform that equilibrates global supply and demand, and rebalances prices. OPEC is once again pulling the strings but the reality in 2016 is not the same as in the 1970s. And OPEC members are well cognizant of this. One thing is certain – the markets are waiting in despair – each headline for a good 6-month period has skewed the pricing curve for oil – levitating freely at the mercy of even the slightest signal for or against OPEC production cut with prices crushing down to the lows of $27 earlier in the year and going up to $53 as a response to cut expectations this week. If an agreement is not reached tomorrow, oil prices might plunge to the range of $20s again.

But would an agreement revamp the weak prices? Not so certain either. OPEC does not hold the same global market share as in the 20th century, thus production cut by OPEC while still important is not merely as significant in the context of increasing North American, but also renewed spike in North Sea production. The Saudi Arabia energy minister Khalid al-Falih seems to have reached the same conclusion – from a vehement supporter of an output cut of up to 1Mbd, on Saturday he confessed that even without a deal the global market is set to rebalance in 2017 – thus indirectly indicating that maybe the deal is not a necessity anymore. The markets reacted instantaneously. Economists and energy analysts were quick to spell the end of optimism for a deal. Precipitous conclusions are rarely worthwhile. His statement belies two things, a realization that OPEC is not anymore the almighty oil cartel it used to be, and secondly, that internal discords are getting harder to handle. Starting from the latter, Saudi Arabia has found it difficult to convince Iran on the need of cuts, the reticence of Iraq, but also the ambiguous position of Nigeria and Libya, both agreeing on the need of cuts, but demanding exemptions on their own production levels, have all twarted Saudi efforts to reach a collective agreement, in which the Kingdom does not bear the brunt of the output cut. The Saudi diplomacy with Russia has not been too fortuitous either - as a non-OPEC member, which is also coincidently the largest producer of oil in the world, Russian accord to reduce output would have buttressed significantly Saudi internal advocacy. Nevertheless, the closest Putin has come to agreeing on some form of coordination has been a vague commitment not to increase production in 2017 from current levels of about 11.2 Mbd, a slightly different concept from blazantly reducing the actual product drilled. Despite a last-minute discreet negotiations on the issue (Algerian and Venezuelan energy ministers flew into Moscow today), it is unlikely that Russia will significantly change its stance. The country is seriously hit by Western sanctions and cannot allow to further reduce revenue. Also, most of its oil fields are in Siberia where production freeze might render oil fields unexplorable afterwards or require huge investment to restart production.

 For each member individually and for OPEC as an organization, failing to agree on a production cut tomorrow will not be just a single decision amongst many, it will turn into a paradigm for the value of OPEC.

But also, and this is crucial, the Saudi Arabia energy minister's statement shows a realization that OPEC is not the global oil market kingpin anymore. The protracted period of excessive production did not marginalise US shale producers. Letting production increase even further will not change the course of US shale – the nimbleness and resilience of the sector has been well demonstrated over the course of 2016. The latest data from the US Energy Administration shows that producers have added more than 150 new rigs since June with production increase of 100,000 bd expected for 2017. The US shale producers are here to stay with or without production cut from OPEC. The Trump promised deregulation of the sector if anything would fortify this trend. In the changed global context, OPEC has to act pragmatically. Continuing surplus in the global oil markets for a fourth year in 2017 will depress prices to levels which will make it even uneconomical to drill. This will have reverbating effect on the Gulf states budgets, deficit valuation and equity. Just yesterday, Saudi Arabia announced a new spike of budget cuts amounting to $20 billion and 25% cuts of the budgets of certain ministries. Minister al-Falih and the Saudi leadership without doubt understand this and the comment on the minor impact of a deal is more of negotiation tactic ahead of Wednesday's last diplomatic dealings than a defeat on the outcome.

ECEGA's View: OPEC will agree to a deal. A deal which will not significantly impact the global crude glut - the commitment is for about 1% of global supply - rather it will cement the soft power of the cartel by sending important ripples across the globe on the credibility and strength of OPEC to act in cohort. Saudi Arabian leadership is aware of this. The stakes are too high for the cartel's geopolitical remit to allow failure of the negotiations tommorow. Even for Iran, the most reticent to the cuts member, the gains in term of international credibility and cohesiveness with its Gulf allies will be higher than debunking cooperation and increasing production. Iraq already signaled readiness to follow suit on Monday. For each member individually and for OPEC as an organization, failing to agree on a production cut tomorrow will not be just a single decision amongst many, it will turn into a paradigm for the value of OPEC. A failure to commit to an output cut might easily spell the end of OPEC as a cartel able to function together and in cohort. Certainly, the price to pay geopolitically will be too high for the cartel and for Saudi Arabia.

Once we have the exact numbers on who is reducing production by how much, the key next step is compliance - the output reduction will fortify prices to the mid-$50s range. A tempting development which might provoke certain OPEC members to pump up production to capitalize on the price rally - of course, such a scenario will end up in a depression well into 2017 and beyond and spell the end of the cartel. Immediately after the signing ceremony tomorrow, OPEC needs to put into place an efficient compliance infrastructure to ensure that each cartel member remains true to commitments. Only with a working, effective and transparent commitment which is implemented on national level, OPEC will signal its evolution and continuous relevance in the 20th century geopolitics of energy. The alternative is falling from grace with global oil markets.

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