“We’re going to do what it takes,” Khalid Al-Falih, Saudi Arabia’s energy minister, said in March. But by agreeing to an unexciting extension of cuts on May 25, the Organization of Petroleum Exporting Countries is merely tinkering. Unless the group acts decisively, it faces a slow process of attrition in rebalancing the market.
But it can act decisively in two directions: much deeper cuts, or a longer-term commitment to higher output to scare off competitors.
As Bloomberg’s Julian Lee notes, the current cut is minor compared to past episodes. Previous reductions of 4 million to 5 million barrels per day compare to a commitment of 1.7 million bpd this time. It is even less impressive when considering that this is the first time the cartel has had real (if partial) cooperation from significant non-OPEC producers.
The last three major cuts occurred under different circumstances, though. All were in response to recession-led slumps in demand — the 1998 Asian crisis, 2001 dot-com crash and 2008-2009 global financial meltdown. The current situation more closely resembles the mid-1980s, when rising output from new basins outside OPEC (the North Sea, Mexico and Alaska) meant that the group’s production cuts — in practice, largely Saudi — simply progressively ceded market share while failing to defend a price target.
Proposals have been offered for a manipulation of the market, such as Goldman Sachs’ plan to try to flip it into backwardation. But these require impossible precision and coordination. Within OPEC, Libya and Nigeria cannot control their production levels or make any credible commitments, but rising Nigerian output has brought the country under pressure to consider a cap at some point.
After the decisive re-election of President Hassan Rouhani, Iran is set to tender its giant new Azadegan field for international investors. Iranian output will not rise much for now, but it is certainly not willing to consider additional cuts. Iraq is chafing at its limits, with development resuming at some key fields.
And the two leaders of the new (N)OPEC group, Saudi Arabia and Russia, have to herd the non-OPEC members who have joined, while there is still suspicion over Russia’s full compliance with the agreed limits. There is no prospect of bringing in any more significant producers — Norway, Canada or Brazil. Other adherents to the agreement, such as Kazakhstan and Mexico, have new production in the works, sooner or later.
Al Falih’s predecessor, Ali Al-Naimi, who was dismissed last May, did not want to repeat the experience of the 1980s, when Saudi exports virtually dried up in a fruitless attempt to defend the price. He hoped that this time, a period of sharply lower prices would take care of the shale threat. His strategy worked only partially, and was not given enough time.
The kingdom is not in shape for a price war. Its National Transformation Plan will take years to show a real effect in diversifying the economy away from oil. The recent reinstatement of bonuses and allowances for state employees and the military does not raise confidence in budgetary discipline. Net foreign assets fell below $500 billion in April for the first time since 2011. And the sharp escalation in tensions with Iran since President Donald Trump’s visit to Riyadh dashed hopes of an end to the war in Yemen or a decline in arms spending.
So Saudi Arabia has abandoned Al-Naimi’s strategy in favor of limited cuts, which just encourage competition from shale and other non-OPEC output by providing an implicit price floor around $50 per barrel. Unnoticed in the uproar about shale, Norway and deep-water producers such as Brazil have also managed to cut their costs sharply and return to production growth.
Since OPEC has failed to dam the flood of capital into shale in the short term, perhaps it can do so in the long term. It could also deter investment into higher-cost, long lead-time conventional projects; encourage rising demand; and discourage competing technologies such as electric vehicles. And it can provide an answer to the conundrum: What happens when cuts expire, assuming inventories are by then back around “normal” levels?
In this approach, OPEC would continue the current cuts — or deepen them, if possible — for a limited period. But it would credibly commit after that to a transition to consistently higher output and so lower prices. If “$60 is the magic number,” as one Permian Basin private equity investor opined, then the exporters’ organization should keep prices well below that. This is similar to Goldman Sachs’ proposal, but does not rely on trying to manipulate the shape of the futures curve. OPEC should wield a bludgeon, not a scalpel.
Such a credible commitment requires approval of a pipeline of new oil production, alongside retooling the oil exporters’ economies to enable them to survive. Led by the Saudis, this strategy would help gain the adherence of members such as Iran and Iraq — and non-OPEC Russia — which have aspirations for higher output.
Of course, this approach would be deeply opposed by weaker OPEC members, notably Venezuela, but there is not much they can do about it. It carries risks, even the breakdown of OPEC, but so does the strategy of smoothing shale’s path with minor cuts that neither boost prices much nor gain market share. Promising to “do what it takes” calls for bold thinking.