US WTI and International Brent Oil Price per Barrel, in US Dollars

Source: EIA

This was precipitated by two factors. First, Libya was returning substantial production to the market, increasing supply by 750,000 barrels per day (bpd) in just four months. This surge in production would be sufficient to meet global demand growth all by itself. But there was more. By the middle of this summer, North American unconventional production was soaring, up 2 million bpd compared to a year earlier.

Without offsetting Opec production cuts, shales and returning Libyan production were more than ample to swamp global markets. When traders perceived that Saudi Arabia would be unwilling to reduce its own output to offset production growth elsewhere, oil prices dipped sharply.

But now comes the interesting part. Given that oil prices have plummeted, how should Opec respond?

On current trends, a number of forecasters are putting Brent oil prices in the $70 a barrel range by the end of March next year. This is well below the $80-$85 a barrel generally thought to represent the break-even price for US shales.

Thus, current Opec policies envision selling oil below its replacement cost in international terms. Is this a wise decision?

It is not an easy call. Right now, most analysts see an excess of supply over demand of about 1 million bpd, perhaps more. Until this excess supply is worked off, oil prices will remain below marginal cost – by as much as $10 to $15 a barrel – to discourage production. The correction could require up to a year, and prices could fall further than anticipated in the interim.

Thus, Opec faces a choice – maintain current production levels and accept a discount of $10 to $15 a barrel (12 to 18 per cent), or reduce production by 1 million bpd, about 3 per cent, to bring prices back to international marginal cost. This would seem to be a simple enough calculation – Opec should cut production. But the decision is fraught with its own uncertainties and problems.

First, who would cut production? The Libyans remain well below their traditional quotas, as are the Iranians. The Iraqis would like to increase production, and countries such as Venezuela have not been able to produce at quota levels in recent years in any event. Essentially, this leaves Saudi Arabia, Kuwait and the UAE to carry the burden. If these three countries cut production by 5 per cent, then Opec output would fall by 750,000 bpd. Such a reduction could be helpful, but perhaps not quite enough to push prices back to $85 a barrel.

Then there is the matter of clawing back market share. A 500,000 bpd Saudi production cut would imply less than 9 million bpd of crude output for the kingdom, its lowest level since just after the end of the Great Recession in the United States in 2010.

Having made these cuts, would Saudi Arabia be able to regain market share over time? What is the risk that shale break-even costs continue to decline, that Libya unexpectedly continues to increase its production, or that Iraq increases its own production faster than anticipated? Saudi Arabia could find that it had cut production without any obvious re-entry point down the line. Reducing output now could prove to be in vain, and all the benefit would accrue to other Opec members, or in the worst case, might fail to stem North American production gains.

And then there is the matter of politics. Iranian-American negotiations regarding the former’s nuclear programme have reached a critical juncture, and Saudi interests dictate that Iran should capitulate. This motivates the kingdom to keep the pressure on, or at a minimum, yield no favour to the Iranians by reducing Saudi production unilaterally. Such regional politics also argue against production cuts.

In the end, Saudi Arabia, Kuwait and the UAE may agree to smaller production cuts totalling perhaps 200,000 to 400,000 bpd, with the intent to demonstrate their allegiance to Opec and willingness to act for the common good. This may help oil prices a bit, but is unlikely to upend fundamentals. Most likely, such cuts would provide the appearance of cooperating without doing too much of substance.

On the other hand, Saudi Arabia may be willing to hold a hard line. Having paid the price of admission to the show, Saudi Arabia may be willing to wait a few months and see how low oil prices influence both production and consumption. Six to 12 months of depressed prices would show how the world has changed, or not, since 2007.

In any event, major Opec production cuts are hard to conceive unless led by countries other than Saudi Arabia, Kuwait or the Emirates. If Venezuela, Libya and Iran want to lead with cuts, then the Gulf states may well cooperate. Barring such an eventuality, however, Opec may be unable to agree on new policy, and the meeting in Vienna will only reinforce the trend towards lower prices well into next year.