The Fuse

Will OPEC’s Production Cut Delay the Neutral Zone’s Return?

by Andrea Alie | March 13, 2017

The Partitioned Neutral Zone (PNZ) is a 3,600-mile area shared by Saudi Arabia and Kuwait which, until the discovery of oil there in 1950, garnered little attention. Soon after, the countries signed an agreement for the production of oil and division of profits in a 50/50 split. While the deal was equitable, the benefits to Kuwait have outweighed those to Saudi Arabia. Riyadh’s oil production capacity of 12.5 million barrels per day (mbd) dwarfs Kuwait City’s 3 mbd. Thus, the additional 500,000 barrels per day (b/d) from the PNZ represents a significant share of Kuwait’s capacity as it seeks to increase output by 1 mbd by 2020. With OPEC now throttling back production to tighten fundamentals and boost prices, the return of the PNZ is in doubt.

With OPEC now throttling back production to tighten fundamentals and boost prices, the return of the PNZ is in doubt.

It appears unlikely that the PNZ fields will resume production while the OPEC cut is in place due to the mitigated value of the fields since Kuwait and Saudi Arabia cannot garner additional profits from the output. If there is an extension of the OPEC cut in May, then a re-start date would likely be pushed to Q4 2017 or into 2018 as a result of a lack of short-term benefits for Kuwait and Saudi Arabia.

Key fields shut

The symbiotic relationship between the two countries stalled when increased political tensions resulted in the shutdown of two key PNZ fields, the onshore Wafra Oil Field and the offshore Khafji Oil Field, which produce approximately 200,000 b/d and 300,000 b/d, respectively. The dispute originated in 2009 when Saudi Arabia unilaterally awarded a 30-year contract extension to Saudi Chevron for operations in the Wafra Field.

The resulting political deterioration culminated in Kuwait denying work visas for Chevron’s staff, forcing the facility to close in October 2014. Seven months later, the Khafji Oil Field also closed for “unspecified environmental reasons,” likely related to the disagreement over a proposed expansion of the Khafji field that would have abutted an operating field in Saudi Arabia’s sovereign territory. As shown below, the slowdown in production of Wafra occurred rapidly between Q3 2014 and Q4 2014, dropping 50 percent to 200,000 b/d. The incremental decline from the Khafji field proceeded until the end of Q4 2015 when all production from the PNZ ceased.

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Impact of OPEC policy measures

Reports first surfaced in May 2015 that an anticipated restart of the fields could take a year or more. Discussions continued during a state visit by Saudi Arabia in December 2016 after which Kuwaiti Oil Minister Essam al-Marzouq said: “Any increase in production from certain areas will be balanced by equal reductions in other regions.” That statement indicates a restart would still take place despite the recently agreed upon OPEC production cut. Saudi Arabia agreed to a 486,000 b/d cut while Kuwait said it would throttle back by 131,000 b/d at the November OPEC meeting, and as of now, both countries have exceeded those targets.

In a January 25, 2017 interview, al-Marzouq reiterated this stance on maintaining the production quota once the PNZ fields are restarted while leaving the timeframe unspecified. He said, “We need to bring back workers to the fields to start maintenance of wells before we start, so it will take some time before we can bring back production.”

However, OPEC’s decision to maintain blocwide production quotas will have significant implications on the timeline for when PNZ production might resume. Although crude has not reached the reported target price of $60 per barrel, OPEC oil ministers have not confirmed whether the extension of the production cut is definite. But most are acknowledging they may need to maintain output curbs to bring down inventory levels. This target price is a benchmark for most OPEC countries to earn a higher profit and stem the net outflow of foreign reserves that most, including Saudi Arabia, have experienced in the low price environment.

The combination of rising oil prices and the revival of U.S. shale production has created a new set of challenges for the re-start of the PNZ fields for Kuwait and Saudi Arabia.

In November 2016, OPEC members banded together in an attempt to speed up a market rebalance by reducing their output to ease the market glut. While the price of oil rose since the cut was announced in November, the re-emergence of U.S. shale has limited price gains due to a production increase of 200,000 b/d in February. For the two years prior to the cut, the Saudi strategy sought to allow the oil market to sink in order to drive out U.S. shale competition. However, shale proved more resilient than anticipated. This combination of rising oil prices and the revival of U.S. shale production has created a new set of challenges for the re-start of the PNZ fields for Kuwait and Saudi Arabia.

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Kuwait and Saudi Arabia have some of the lowest oil production costs in the world at $10 and $8.50 per barrel respectively, setting their domestic priorities at odds with higher-cost OPEC producers such as Venezuela, whose costs hover around $30 per barrel. As shown in the graph, the 2017 fiscal breakeven prices for both countries declined as government budgets were trimmed to better financially withstand the current price environment. Oil revenue accounts for 50 percent of Saudi Arabia’s GDP and up to 60 percent of Kuwait’s GDP. Thus, both countries have interest in the stabilization of the oil market and higher oil prices.

Future considerations

In the long-run, the PNZ fields are strategically important to both Kuwait and Saudi Arabia because they offer “new” oil and gas reserves without the cost or complexity of investing in foreign countries. In the January interview referenced earlier, al-Marzouq also touched upon the fact that maintenance will be needed before the fields can restart production as the facilities have been offline since 2014. While the costs were not specified, they are a factor for Saudi Arabia and Kuwait to weigh when picking a commencement date.

In the long-run, the PNZ fields are strategically important to both Kuwait and Saudi Arabia because they offer “new” oil and gas reserves without the cost or complexity of investing in foreign countries.

Renewed Neutral Zone production would provide economic benefits to Saudi Arabia and Kuwait. However, the current commitment to OPEC’s production quotas likely means a delay in the Wafra and Khafji Oil Fields return, originally expected for mid-2017. Though a timeline remains unspecified, recent interviews with Kuwait’s oil minister have reinforced the position that both countries envision bringing the fields back online. These statements, existing infrastructure, and ability for a quick re-start, lend themselves to an eventual return of PNZ production but for now that announcement remains awaited as OPEC seeks to continue to implement its deal.

 

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