Security & Geopolitics

OPEC Deal Extension: Who is Leading the Oil Market?

Opec agreed to extend the cut until December 2018. Many see Russia as the new swing producer, but Saudi Arabia still seems to have a lot to say.

On the 30th of November in Vienna, the 173rd Opec meeting took place.
The biggest question around this meeting was whether or not Opec was going to maintain the output restraints put in place in 2017 that restored some fragile equilibrium in the oil market.
The decision was that output cuts remain in place, until the end of 2018, maybe.
To better understand the significance of the deal, it is useful to take a step back and look at how Opec approached the oil market since prices started collapsing in 2014.

The Prequel

Since the early 2000s unconventional oil production has been rising at a fast pace, lured by high oil prices.
Reacting to the emergence of many new competitors – the most aggressive of it being the U.S. with its shale oil production – Opec opted for a market share strategy.
That meant that it literally did nothing.
Many at the time argued that the power of the cartel to determine the dynamics and the prices of the oil market was over. But that was only partially true.
Even allowing that Opec ever had that sort of exclusive power, it still seems in the position of influencing global oil prices.

In fact, the decision of Opec was not determined by a sense of impotence, but rather by a lucid strategy of its leader, Saudi Arabia.
The Kingdom had historically plaid the role of the swing producer – the one that adjusts its output to meet global demand swings. In this role, Saudi Arabia has often borne heavy cuts in its production when it was necessary to reduce Opec overall production, especially because lack of effort from fellow Opec members.
In this context, the presence of growing non-Opec production would have made this mechanism too risky. To avoid loosing big chunks of market share to other producers, Saudi Arabia decided to let the market regulate itself.

Unconventional oil had back production costs much higher compared with those of conventional oil. Conscious that an oil glut was going to result in lower oil prices, Saudi Arabia hoped that those new competitors could not bear the losses and leave the market, maybe for good.
The Saudis let the glut happen. The prices plummeted starting in 2014 and the Saudis did not restrain production. They stubbornly refused to do so even when fellow Opec members like Nigeria and Venezuela vocally called for production cuts.
The plan seemed working, to a certain extent.
Many U.S. shale producers stopped production, crushed under the weight of heavy losses. But not all of them. In general, the U.S. industry proved more flexible than expected, improving the technology and lowering production costs. The U.S. was still in the game, and Saudi Arabia was still there too, watching and waiting, patiently.
Prices reached $30 a barrel, and still, the Americans kept drilling.
At that point, when the losses reached a too high level, and when it was clear that U.S. shale oil was there to stay, Saudi Arabia updated its strategy and decided to intervene.

In November 2016 Opec struck a deal with some non-Opec producers, the biggest of them was Russia. The commitment was to cut 1.8 mbd, with Opec member cutting 1.2 mbd, Russia 300.000 bd and other non-Opec producers 300.000 bd.
Effective by 1 January 2017, the deal delivered the desired outcome. Prices slowly recovered and recently reached $60 a barrel.
This was the context where the decision of last week took place.

The Deal

At this point any strategy was a double-edged sword.
If the oil surplus is completely removed from the market, prices will probably increase, thus boosting unconventional production. If the surplus is not removed prices will not increase beyond a certain extent.
This dilemma was the reason why the decision of Opec was not to be taken for granted.

Taking stock of the effect of output cuts so far, Opec stressed how OECD stock has halved, reaching a current level of 140 mb, with oil demand growth so far forecasted to be at 1.5 mbd for 2018.
Confident that the strategy that is proving effective would keep working in the future, the end result of the meeting was an extension of the output cut until the end of 2018.
Among the 24 Opec and non-Opec countries participating in the deal, there are Nigeria and Libya that have been exempted until now because of political instability that already affected production levels. The decision of Opec was to cap their combined production at 2.8 mbd, technically 1.8 mbd for Nigeria and 1 mbd for Libya.
The agreement envisages the possibility of ending the output cuts prior to the end of 2018 in case the oil glut is definitely removed and prices increase to a level that they also notably increase competition.

Many commentators defined this exit strategy as a victory for Russia, afraid of increasing competition from the U.S. and apparently more impatient of getting rid of any kind of restriction.
It is to be said, however, that this strategy is quite consistent with the one adopted by Saudi Arabia in the last four years or so.
Mindful of how flexible U.S. shale production is, Saudi Arabia decided to maintain the same level of flexibility in its approach. No decision was ever made quickly, impulsively and to reach a short-term gain.
The main strategy has always been to make few, thought through changes, observe their impact and overall wait, and see.
The Saudi Energy Minister Khalid al-Falih assured that there will be no exit before two quarters and if there will ever be, it will be gradual, to avoid shocks in the market. If, and only if further adjustments will be necessary, these will be adopted, as it has always been in the past.
Russia may have gained a more flexible mechanism, but this does not necessarily mean it gained the upper hand on the Saudis.

The Sequel

In the next few months we will see if the deal extension is enough to restore market equilibrium, remove the oil glut and drive prices upwards.
The Saudis will likely do most of the job, but Russia is cooperating and overall compliance is very high. In fact, last October was the first month that Opec and non-Opec members honoured their commitment to cut production.
Much of the efficacy of the deal will depend on compliance level, but all participants seem to be on the same page.

Again, Saudi Arabia is playing the role of the leader, knowing when it is time to make concessions and when it is better to tighten the ranks.

Again, watch and see.