A capitulation to markets


Valerie Marcel

LONDON, Jan 27


OPEC and non-OPEC countries are congratulating themselves about their production cut and higher prices. But they only succeeded in lifting prices temporarily. Fundamentals have not changed. Shale oil in the U.S. today is at the same level as it was when the war on shale began.

OPEC cannot hold back production without losing market share. Minister Falih will come to the same conclusion as Naimi in 2014: better to sell your oil to whomever will buy it. With the difference that Naimi was strategic about flooding markets. Falih will be capitulating to markets. In this new, unregulated market, prices will be volatile and producers will need to diversify (their economies) or die.


Last weekend saw the oil ministers of OPEC member countries and their new non-OPEC allies congratulating themselves for the high rate of compliance to promised production cuts and the increase in oil price.

Producers everywhere are breathing easier under a $55 barrel.

But this celebration is under a heavy cloud: U.S. shale oil production is now at the same level it was just over two years ago, when Saudi Oil Minister Ali al-Naimi started what many analysts called the “war on shale”.

OPEC efforts at balancing markets have backfired yet again, and they will eventually come to realise the game is no longer worth playing.

OPEC had pulled off an impressive feat last December, under the direction of Saudi minister Khalid al-Falih, bringing 11 non-OPEC producers on board for a production cut of 558,000 barrels per day (bpd), bolstering OPEC’s own 1.2 million bpd cut.

With a compliance rate of about 80 percent and good messaging the oil price gained 20 percent by January. Longer term, though, he will struggle to keep prices high.

His predecessor, Ali Naimi, concluded in 2013-14 that Saudi Arabia cannot cut production alone without losing market share to its OPEC rivals (notably Iran).

This explains the Kingdom’s loss of appetite for the swing producer role, its time honoured job as the global central bank of oil.

He concluded that OPEC would gain more by letting the market regulate itself, allowing prices to slide, and making it too painful for the upstart U.S. shale oil producers to stay in business.

It was a waiting game, which Naimi thought he had time to play – in time, lower prices would eradicate higher price U.S. shale and unconventional oil.

But, he didn’t have the time, as the fiscal pressure on OPEC producers grew under a falling oil price.

Last spring he orchestrated a concerted production cut that included Russia, Qatar and Venezuela but his inability to get Iran on board led to his dismissal in May.

In the fall of 2016, new oil minister Khalid al-Falih took a lesson from Naimi’s playbook and built a new OPEC and non-OPEC coalition to cut back production.

Again, Iran was exempt from cuts but the coalition was broader, which minimised the loss of Saudi market share to free riders.

The result at the December meeting was a success with regards to the price, but it will be short-lived and hides the limits of the cartel’s paucity of power.

The deal did not change the market fundamentals. U.S. shale oil production was not knocked back.

In fact, the IEA and the EIA both forecast shale oil production capacity to rise in 2017. New production is expected from Brazil and Canada. Inventories are down, but not enough. Global demand is following an uncertain path.

Critically, the industry is more robust in a lower price range thanks to significant cost reductions and improved project optimisation.

We now see that U.S. shale oil is resilient at $40 per barrel and positively buoyant at $55. We also now know that its production can be ramped up very quickly.

For these reasons, Khalid al-Falih will come to Ali Naimi’s conclusion – or maybe already has – that it is best to sell what you can at the price you can get.

But this time the decision to leave markets to rule won’t be seen as a strategic one – like Naimi’s big gamble – but a capitulation to a market Saudi Arabia and OPEC cannot control.

This market on autopilot is a more challenging one to invest in. Just looking to the last few years, we see investment down by 25 percent and discoveries at a 70-year low. With the uncertainty involved, it is also increasingly challenging to secure finance.

Saudi Arabia, and indeed all producers, have to be prepared to live with a more volatile oil market and lower priced oil. They will need to build national economies that are more resilient and less sensitive to oil price fluctuations.

This explains the fervour with which the kingdom is pursuing its diversification agenda under Vision 2030. The new motto of oil producers (national and private) will be “diversify or die”. (Editing by Jason Neely)

Valerie Marcel is an associate fellow at Chatham House in London. The opinions expressed here are those of the author.

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