OPEC Is in its Death Throes

Like the boy who cried wolf, 2016 might become the year of the oil producers’ cartel that cried “output cut.” If that’s right, and the U.S. shale industry becomes the oil market’s marginal producer, Middle Eastern petro-states and, above all, Saudi Arabia are in for lean and hard years ahead.

In February, OPEC called for an oil production “freeze” to raise crude prices in conjunction with Russia. But this effort collapsed at a meeting in Doha, Qatar, in April when Iran refused to join any freeze in order to regain the pre-2012 production levels of close to 4 mbpd it enjoyed before U.S. and European Union nuclear sanctions were imposed, following the removal of certain sanctions after the 2015 nuclear deal. A similar proposal failed at the OPEC meeting in June, again following Iran’s refusal, despite outreach by the Qataris.

Having dashed market hopes and crude prices in February, April, and June, OPEC again called for a form of output cut on Sept. 28 at an extraordinary meeting in Algiers. Markets bit on the news, with Brent prices rising sharply by about 15 percent in the following week, from $46 to $52 per barrel.

So should markets now take OPEC seriously? Can action by the cartel sustain higher crude prices over the long term? Probably not. Like a desert mirage, the image of an OPEC resurrection vanishes when approached.

OPEC, which has always been dominated by Saudi Arabia, went into hibernation in the summer of 2014. The massive fall in oil prices from over $100 per barrel in early 2014 to under $30 by January 2016 was caused primarily by then-Saudi Minister of Petroleum Ali al-Naimi’s strategy to gain market share for the kingdom and hurt the U.S. tight oil (or “shale”) industry by allowing the market, not OPEC interventions, to set prices.

The results have been mixed. While Riyadh has cranked up its production from mid-2014 to today by over a million barrels a day (to a peak of 10.7 mbpd in August this year), its fiscal position has taken a serious blow, with the budget deficit rising from 3 percent of GDP to 16 percent in 2015, given how about 90 percent of government revenue comes from oil.

As for U.S. shale, the industry has been more resilient than Saudi Arabia expected, as I suggested in my New Year’s prediction. The rig count is down, and only the most profitable new wells — for example in part of the Permian Basin in Texas — can boast of breaking even at less than $35 per barrel. However, U.S. oil production, of which shale accounts for about half, is on track to produce an average of 8.7 mbpd this year, down from a peak of 9.5 mbpd in 2015. Down, but by no means out.

The resilience of U.S. shale makes the argument that OPEC has experienced a resurrection a fragile claim. The cartel can probably raise prices in the short term through an output cut, but it will only be so long, perhaps already by mid-2017, before the U.S. shale industry revives and grabs any market share conceded by OPEC in a higher price environment. This will ultimately bring prices lower again, all else being equal.

The OPEC resurrection claim becomes more tenuous when one considers the Algiers announcement, which is only an “agreement to agree” to production cuts at the next OPEC meeting on Nov. 30. Inauspiciously, the specific cuts individual members must make haven’t been agreed upon, but kicked down the road for discussion by a “high-level committee.”

Moreover, to reach a provisional agreement in Algiers, Naimi’s successor, Saudi Arabian Energy Minister Khalid al-Falih, had to exempt Iran, Libya, and Nigeria from any participation in production cuts. This represents a major geopolitical concession by Riyadh to Tehran, arguably brokered by Moscow, which will not be an easy position to sustain, given Saudi-Iranian animosity.

The provisional deal in Algiers leaves Saudi Arabia having to do most of the heavy lifting. While the kingdom’s production will in any case fall from 10.7 mbpd by about 300,000 barrels per day over the coming months, as seasonal production winds down, it would need to cut substantially more to balance the market. The production target OPEC named in Algiers implies a cut of at least 700,000 barrels. (While officially, OPEC wants to cut from 33.2 mbpd in August 2015 to a range of 32.5 to 33 mbpd, unofficial data suggest actual OPEC production in September was 33.6 mbpd.)

Within OPEC, while other Gulf Co-Operation states, namely Kuwait and the United Arab Emirates, may be prepared to make a small cut to their production, key producers like Iraq and Venezuela are in too difficult a fiscal position to agree to any major cut. They will more likely agree to a freeze, given that they are already close to maximum production (4.4 and 2.1 mbpd, respectively).

Outside OPEC, Russia reached a production record of 11.1 mbpd in August, eclipsing Soviet levels. Being so close to the maximum anyway, Russia has little to lose by supporting the OPEC output cut and agreeing not to raise production further. Yet the Kremlin is unlikely to impose actual cuts on the range of oil companies that operate in the country.

So why did Saudi policymakers blink and commit themselves either to sponsoring another failed OPEC deal, or having to take the hit for the vast majority of the actual production-cutting to make the deal work?

In the short term, it seems Riyadh’s fiscal position was under such pressure from low oil prices that something had to give. While the kingdom has eased the fiscal pressure by starting to issue sovereign debt, the burn rate through its foreign reserves has been relentless (from about $740 billion in mid-2014 to $550 billion today) as it has attempted to defend the currency in the face of substantial capital flight from the country since the oil price crash in 2014.

In the long term, Saudi Arabia’s energetic and ambitious young deputy crown prince, Mohammed bin Salman, appears to see beyond the immediate threat of U.S. shale to the Saudi oil industry. He is focused on the broader need for major reform of the Saudi economy. As OPEC’s first secretary-general Ahmed Zaki Yamani said in the 1970s, “The Stone Age didn’t end because we ran out of stones.” Climate change will plainly be a major problem of the 21st century, and the world is moving away from fossil fuels: game over for an unreformed Saudi Arabia.

Algiers wasn’t a sign of life in OPEC, but a sign of desperation. In truth, there’s little the cartel can do beyond the short term to generate a durable rise in prices from a supply perspective, since shale technology can’t be un-invented. Saudi Arabia will face hard years ahead as the oil market increasingly looks to U.S. shale, not OPEC, as a handrail to oil prices on the supply side. However, this might well be the jolt that Salman needs to push through painful but necessary reforms. Good luck to him.