The conventional view on OPEC is that the cartel won’t cut output at its upcoming meeting in December or in 2016, as its de facto leader Saudi Arabia will continue to sacrifice price for market share for as long as necessary. While the producer group may in fact hold steady throughout 2016 and ride out the low-price environment, there is good reason to speculate that a variety of scenarios could instigate a cut. For Saudi Arabia, or the group as a whole, to act, it would take more than one of the factors below to occur.
While the producer group may in fact hold steady throughout 2016 and ride out the low-price environment, there is good reason to speculate that a variety of scenarios could instigate a cut.
A production cut next year is not entirely unrealistic, given that higher volumes from Iraq and Iran, along with the possibility of continued elevated U.S. output, could very well keep the global market oversaturated and drive down prices even further. The Saudis are in the best position to ride out a price collapse longer than anyone else, but the Kingdom, and by extension OPEC, may be compelled, under certain circumstances, to cut production, whether the pullback in output is stated explicitly at an organization meeting or done informally behind the scenes.
- A growing surplus and an extended period of $20-$30 oil
Oil prices reversing course and falling to the $20-$30 level is a very realistic possibility, and the scenario would not serve any producer well, including the Saudis. With Iran poised to increase exports after sanctions are lifted and Iraq eyeing higher production to make up for lower oil prices and to finance the fight against the Islamic State, the group could be producing well above 32 million barrels per day (mbd) in 2016, versus year-to-date average of 31.17 mbd. Ballooning production would become even more of a risk if Libya settles down, given that the North African country can add some 1 mbd very quickly if political issues are resolved. With higher levels from OPEC, it’s unlikely that losses in U.S. output, which is still above 9 mbd, will be enough to rebalance the market.
Prices still have the potential for another leg down—oil in the $20 neighborhood is a nightmare for all producers, and would create a possibility for Saudi Arabia to pull back some of its supply, even if it’s unlikely that the Kingdom would entirely accept the burden of rebalancing the market.
Libya, Iraq and Iran have been dealing with instability and outages for so long that they’ll increase production no matter what the price, and undersell the competition to make up for past shortfalls. The Saudis, however, have to factor in a breakeven price, which has exploded in recent years to $100 per barrel. The Saudi strategy has brought about a lot of financial pain for both non-OPEC producers and those inside the organization, but the kingdom, while keeping output above 10 mbd, is also hurting as it burns through foreign assets at a rapid pace and has to rely on oil for 90 percent of fiscal revenues. In other words, prices still have the potential for another leg down—oil in the $20 neighborhood is a nightmare for all producers, and would create a possibility for Saudi Arabia to pull back some of its supply, even if it’s unlikely that the Kingdom would accept the burden of rebalancing the market entirely.
- Pressure from other Gulf Cooperation Council (GCC) members
While it’s clear Saudi Arabia has no love for Iraq or Iran and has no desire to throttle back to accommodate their increased volumes, the Saudis’ relationship with Arab Gulf OPEC members is more complex and the Kingdom might at least entertain their suggestions for a cut. Kuwait, Qatar and the UAE, which make up 20 percent of OPEC’s market share, have strong economic ties with Saudi Arabia and enjoyed an investment boom on the back of high oil prices. They also have foreign currency reserves to cushion against the extended period of low prices. But even though none of these countries are experiencing the turmoil seen in price hawks Venezuela and Nigeria, it’s in their longer-term economic interests to shore up prices. Their economies have grown at some of the fastest rates in the world in recent years, but have stalled in 2015. They need to diversify their economies and all want to keep dissent at bay, similar goals to the Saudis, but forecasts call for fiscal deficits as current oil prices are well below breakeven prices for most GCC countries. The GCC members have more influence on the Saudis than price hawks or non-OPEC producers for another reason: The Arab states would actually go forward with an output cut so the kingdom doesn’t carry all the weight. It’s important to note that a coordinated cut among the these four members, which make up more than 50 percent of OPEC’s output, would not necessarily come during an OPEC meeting, but more likely would emerge as the result of an informal agreement.
- A flip in benchmark differentials
If U.S. benchmark West Texas Intermediate (WTI) begins to trade at a premium to European marker Brent, OPEC has a big problem on its hands.
If U.S. benchmark West Texas Intermediate (WTI) begins to trade at a premium to European marker Brent, OPEC has a big problem on its hands. Such an event would signal that the main reason for the oversupplied market has shifted from U.S. shale to global producers—namely OPEC. U.S. production, while performing better than expected, has declined from its peak in April, and could continue to fall throughout the rest of the year, tightening the U.S. market relative to the rest of the world. In fact, WTI is now only about $3 under Brent. Continued production declines in the U.S. will occur alongside higher OPEC supply, a scenario that would cause the benchmarks to flip. From 2009-2014, OPEC members and other producers outside the U.S. enjoyed a steady, and at times massive, premium to WTI. That advantage is slowly eroding. In order to push Brent back over WTI, OPEC would have to throttle back to get more for their crude than what producers in the U.S. are making.
- Weaker economic growth
Last year’s price collapse was driven by supply-side developments, but a demand shock will test OPEC in a different way.
Last year’s price collapse was driven by supply-side developments, but a demand shock will test OPEC in a different way. In 2008-09, in wake of the global financial crisis, when OPEC cut production, the Saudis cut back by as much as 1.7 mbd, putting total output briefly below 8 mbd. The recession had wiped away a large chunk of oil demand and sent oil prices into the $30-$40 range, making an output cut an easy decision. While a financial crisis similar to 2008 is unlikely, oil demand growth in some economies is under threat from a number of economic headwinds. Stronger demand from lower prices was supposed to be part of the strategy of rebalancing, but if demand doesn’t materialize, action similar to 2008-09 would be necessary to manage the glut. The biggest worry in this regard is China, which is expected to make up 25 percent of demand growth next year. China’s economy is forecast to grow by 6.8 percent this year and 6.3 percent in 2016, versus 7.4 percent last year. A sharper-than-expected downturn would have an outsized effect on oil markets, and on OPEC producers in particular, as the demand for their oil should rise by 1.6 mbd in 2016. But what if it doesn’t?
- The need to boost OPEC & Saudi Arabia’s credibility
Questions about the organization’s future and Saudi returning to its key role as the swing supplier will be ongoing. They may not come to the fore in 2016, but an oil market that looks entirely different from today could prompt these questions to be answered sooner rather than later.
Saudi Arabia’s decision not to cut output last November meant it abdicated its role as swing producer and prompted questions about the future of the cartel. With the Saudi strategy now allowing free market forces to rebalance supply-demand fundamentals, what’s the relevance of OPEC? And what’s the significance of OPEC when one member dominates its decision-making? Since the global market does not have a swing producer, U.S. shale has become the effective marginal barrel—the production that would be first eliminated by lower prices or higher costs. Against this backdrop, U.S. producers effectively have the most influence on oil market direction. The Saudis have at times relished their role as the swing producer, manipulating supply levels to cap prices on the upside and limit output to put a floor under the market, ensuring market stability for both consumers and producers. Is it ready to fully relinquish their status as the world’s most watched producer? A repeat of the 1980s is one major concern for Saudi Arabia, when it cut by a spectacular 6.4 mbd and in turn supported higher-cost non-OPEC supply—but it would not need to take such drastic measures this time to tighten fundamentals and support prices. A cut of .5 to 1 mbd would change the psychology of the market and motivate speculators to bet on higher prices. The last two rounds of major cuts—in 1998-9 and 2008—helped save the cartel’s credibility when it was facing similar criticisms about its relevancy. The critical questions about the organization’s future and Saudi returning to its key role as the swing supplier will be ongoing, and presumably wouldn’t be enough to prompt a cut in-and-of itself. This issue may not come to the fore in 2016, but an oil market that looks entirely different from today could prompt these questions to be answered sooner rather than later.