The Fuse

OPEC: Breaking Down Naimi’s ‘Lack of Trust’

by Matt Piotrowski | March 01, 2016

“We are not banking on cuts… because there is less trust than normal,” said Saudi Oil Minister Ali al-Naimi last week in Houston, in an address to industry leaders at IHS CERAWeek. His comments focused on the fact that although Saudi Arabia has repeatedly stated willingness to collaborate on collective oil production cuts, the Minister is pointing to a lack of credibility and accountability among OPEC members and Russia, which will likely undermine a meaningful production cut.

The issues of distrust among OPEC members that Minister Naimi was referencing date back to the group’s inception, although they have compounded over the years.

These issues among OPEC members that Minister Naimi was referencing date back to the group’s inception, although they have compounded over the years. Throughout the cartel’s history, members have overproduced, in order to sell more volumes and boost revenues, sometimes by excessive amounts, causing widespread suspicion and distrust. The long-standing individual quota system, abandoned in 2008, was flawed from the beginning because there was no way to enforce compliance, and some countries were not pleased with the targets they were allocated. Furthermore, during the first part of the 1980s, Saudi Arabia disproportionately cut production to support prices, while other OPEC members cheated on their agreements. In 1998, Saudi Arabia boosted output sharply to undermine prices in order to get others, particularly Venezuela, to fall in line and be disciplined with output.

The lack of trust remained deep during the past decade, causing disharmony among both members and non-members alike. Since 2008’s decision to eliminate individual country quotas, OPEC has revised the group’s ceiling, repeatedly produced above that number, and most recently failed to establish a collective target at its latest mee­ting in December. In 2011, the group couldn’t agree on a production strategy at its “worst meeting” ever. And since the late 1990s, Russia and OPEC have tried and failed to cooperate on multiple occasions. The ongoing distrust, along with the nimbleness of U.S. shale, has kept OPEC from taking action to lift prices since they fell precipitously in mid-2014.

With the cartel in such disarray, some have been quick to deem it irrelevant. But it’s important to note its members control a third of the world’s production and some 80 percent of the world’s reserves.

With the cartel in such disarray, some have been quick to deem it irrelevant. But it’s important to note its members control a third of the world’s production and some 80 percent of the world’s reserves. The current lack of confidence among members doesn’t take away from their overall market power. Moreover, with the current production “freeze”—which includes Saudi Arabia, Venezuela and Qatar, along with non-OPEC supplier Russia, agreeing to not increase output—members may eventually regain a enough trust to take action to remove excess supply and shore up prices.

Individual quotas in 2007 and 2008 Cut

Some of the seeds of the current distrust could be seen at the end of the last decade when OPEC was dealing with an unrelenting price rise, and subsequent crash.

Some of the seeds of the current distrust could be seen at the end of the last decade when OPEC was dealing with an unrelenting price rise, and subsequent crash. The last time OPEC announced actual quotas for individual countries came in November 2007. The make-up of the cartel and the outlook for the oil market were very different—prices were on an upward trajectory toward the $147 per barrel record hit in the summer of 2008, while Indonesia was on its way out of OPEC (before being re-admitted last year), and Angola and Ecuador were joining the group.

OPECproduction

By the end of 2008, however, OPEC had to manage a plunging oil market in the wake of the global financial crisis, which significantly undercut global oil demand. The cartel was able to agree to a 4.2 mbd production cut from just above 29 mbd to put the group’s target at 24.85 mbd (excluding Iraq, which was recovering from sanctions and war). Because the issue of individual quotas was so contentious, they were abandoned. The December 2008 meeting, based on the group’s press release, ended with: “Member Countries strongly emphasizing their firm commitment to ensuring that their production is reduced by the individually agreed amounts.” But no actual production allocations were mentioned.

The Saudis assumed the largest share of the burden in the last cut, reducing output by a massive 1.2 mbd, or 43 percent of total volumes cut.

Despite the group’s output target of just under 25 mbd, total production in 2009 was higher, averaging 26.27 mbd. Most members throttled back from September 2008 levels, but the Saudis assumed the largest share of the burden. Saudi Arabia, which accounted for just under 30 percent of total production, reduced output by a massive 1.2 mbd, or 43 percent of total volumes cut. The next year, the issue of members cheating became more of an issue with demand having recovered and inventory levels ballooning. The Saudis increased production by .24 mbd in 2010, but the rise totaled only 3 percent of the country’s total volumes. Venezuela and Nigeria, meanwhile, were the biggest offenders, increasing production by .38 mbd, or 18 percent, and .26 mbd, or 14 percent. Venezuela has been singled out at times as the most notorious OPEC country in producing above its target levels over the decades.

The ‘worst meeting’ ever in 2011, and a new output target

In 2011 and 2012, the cartel’s production volumes continued to grow, leading to the current era of challenges. The increased output stemmed in part from lack of discipline, but also included Iraq’s production growth as part of its post-war recovery and Gulf producers upping output to offset major outages in Libya in 2011 and Iran getting slapped with international sanctions in 2012. OPEC was also facing external existential threats at the time, not least of which was the rapid rise of U.S. shale production.

Much of the group’s current discontent further came to the fore in 2011, when OPEC failed to agree on crude production levels for the first time in about two decades.

Much of the group’s current discontent further came to the fore in 2011, when OPEC failed to agree on crude production levels for the first time in about two decades. At the time, half of the cartel stood in opposition of Saudi Arabia wanting to increase output to stabilize the turbulent market when oil was trading around triple digits, and Libya’s oil sector was in shambles. “It was one of the worst meetings we’ve ever had,” Saudi Oil Minister Ali al-Naimi said.

Even though OPEC appeared in disarray, members reversed course by the end of the year and established a new output ceiling, this time at 30 mbd, marking the first increase since the 24.85 mbd target in 2008. This time the ceiling included Iraq and was based on the group’s output of 30.37 mbd in November 2011. But again, the thorny issue of individual country targets was not touched.

Although the meeting showed signs of harmony among the cartel, it didn’t really work: Agreeing on a new ceiling simply sowed the seeds of further distrust, because in 2012, the cartel’s production surged to well beyond 31 mbd, or 1.36 mbd above its agreed output ceiling. When prorating the group’s ceiling to determine each members’ implied target, Saudi Arabia, Nigeria and Venezuela were the main overproducers. But increasing output at this time had little negative impact on prices since Iran’s exports were falling due to international sanctions, and volatility in Libya continued to be a cause for concern. Furthermore, prices remained stubbornly above $100 per barrel, eliminating any pressing need for the group to reconcile its differences.

All eyes on Russia

Today, the mistrust comes from many different directions. In 2015, the cartel pumped 32.02 mbd (when re-admitted member Indonesia is included), more than 2 mbd above its 2011 ceiling. At OPEC’s most recent December meeting, it failed to state establish a new target despite the high supply levels and low prices.

It’s not only actors with an unreliable history such as Venezuela and Nigeria that Naimi worries about, both of which saw production decline slightly last year due to underinvestment and mismanagement, but fresh challenges are posed by Iran and Iraq. Iran is set to boost its output by .5 mbd in 2016 and needs revenue to recover from years of sanctions. Iraq, meanwhile, wants to tap its ultimate potential and has not been administered an individual quota since the late 1990s. Libya’s output is only around .4 mbd—chances of a return of its exports are low but still possible, and a recovery there would negate the impact of a freeze or cut in rebalancing fundamentals.

There’s a longstanding lack of trust between OPEC and non-OPEC players.

Finally, there’s a longstanding lack of trust between OPEC and non-OPEC players—despite Russia agreeing to a cut in 1998-9, it actually increased output, and the country turned its back on the cartel in 2001 and 2008 when asked to curb volumes. During the price crash of the late 1990s, Russia said it would cut output by 7 percent, but ended up increasing exports by .4 mbd in 1999. With so many moving parts, including the fact that Russia and Saudi Arabia are geopolitical foes with vastly different goals in the Middle East and the outlook for U.S. shale is in flux, trust-building and successful coordination will be a difficult task.

A cut sooner or later?

It’s clear it will take some time for the cartel to regain trust among its members, while also collaborating with major non-OPEC producers such as Russia. But closer cooperation, whether through more joining the freeze or the cartel eventually agreeing on a cut, might happen faster than one thinks, and when agreements are reached, the potential for impact remains great.

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