It is the 18th of January 2020

"The Production Cuts Were Going To Happen Anyway" - An Inside Look At The OPEC "Deal", And How It Happened

Ahead of the OPEC Algiers announcement on September 28, the broad market consensus was that just like in previous summits, there would be no deal and the best market watchers could hope for from the oil producing cartel was an agreement on another meeting, with the requisite future headlines popping up occasionally to push the price of oil higher courtesy of headline scanning algos. However, in a major  surprise, Saudi Arabia appeared to relent and agreed to not only freeze production but to, at least on paper, cut its output by a few hundred thousand barrels - the actual production cuts among OPEC members have yet to be determined - to return total OPEC production from a near record high 33.2 million barrels per day to 32.5mmbd, while exempting arch Saudi enemy - Iran - from the agreement terms, permitting it to pump until it hits pre-sanction levels, or higher.

But how and why did Saudi Arabia relent? That is the answer provided by a probing piece by the WSJ's Summer Said who writes that Saudi Arabia’s deputy crown prince sent his energy minister to an OPEC meeting last month with a difficult mission: Make a deal with rival Iran but don’t compromise the kingdom’s ability to fight for oil-market share.

The directive was a departure for Deputy Crown Prince Mohammed bin Salman, the powerful 31-year-old son of King Salman who is prosecuting Saudi Arabia’s war in Yemen against Iran-backed rebels. Prince Mohammed scuttled previous attempts at oil-production deals with the Organization of the Petroleum Exporting Countries this year as Saudi Arabia worried about Iran’s rising output following the end of Western sanctions.

The shift in the Saudi position over the past two years is shown in the graphic below:

The market's reaction to what has been seen by analysts as a reversal of policy, was to send oil soaring some 13 % since the OPEC deal, with WTI rising above $50 for the first time since June.

But has OPEC once again succeeded in fooling the market? According to the WSJ's report, and people familiar with the matter, any interpretation that the Saudis have changed their tune is incorrect. As Said writes, Prince Mohammed didn’t authorize a sea change in Saudi Arabia’s market-share strategy. While Saudi Arabia will take on the bulk of OPEC’s proposed cuts, slashing up to 400,000 barrels a day by the end of the year, the kingdom was planning to make those cuts anyway, the people said.

As we showed previously what Saudi Arabia effectively did as to "cut" its production from what were already abnormal, record high production levels. Sure enough, the Saudi energy minister Khalid al-Falih could only offer to bring the kingdom down from record highs this summer to more sustainable levels that were pumped in the spring, the people said.

Which means that for all the bluster, OPEC may have simply bluffed with the intention of getting the price of oil above $50, but below $55, at which point crude shale production would return aggressively. This is how Citi's Ed Morse explained the dynamics of the Saudi gambit:

The deal in Algiers is a change of tack for Saudi Arabia and is gamble that it can push prices higher without triggering a resurgence of shale production growth in the US. This is a safe bet as long as prices stay sub $55/bbl, a level that would push the Permian back to growth but that would see the Eagleford and Bakken continue to decline, leaving net growth negligible. The financial stress visible in the declining Saudi foreign reserves may be pushing the Saudis to be more flexible. When Saudi Arabia embarked on the new oil policy back in 2014 it seemed plausible that the Kingdom’s potent combination of low-cost reserves, large financial cushion and small population left it well placed to outlast both US shale producers and Iran in a low oil price world. The reality is that shale has survived and, in the Permian at least, is thriving (the EIA latest DPR forecasts October Permian production to rise by 22 k-b/d), while Iran’s already toughened economy is improving despite the oil price slump. Saudi Arabia agreeing in Algiers to include its traditional regional adversary Iran, along with Nigeria and Libya as special cases is a notable shift away from its earlier position that all OPEC countries would have to participate in a cut.

Citi's assessment is that Algiers was "not a game-changer for the oil market", something corroborated by the WSJ's reporting: "The OPEC deal “is not really a change in the Saudi oil strategy or a big compromise on the Saudis’ part,” said a Saudi oil-industry official. “The kingdom would still be able to meet all of its customers’ demand comfortably at these levels and without losing market share.”

Which suggests that Saudi Arabia is aware that demand out of the biggest marginal consumer in recent years is set to slow, something we also documented recently when we noted that the Chinese Strategic Petroleum Reserve is rapidly approaching capacity, suggesting that demand out of China would decline in the coming months, putting far more pressure on oil prices without a "production cut."

This was confirmed on Wednesday when Saudi Arabia cut the prices it charges for oil in key markets in Asia and Europe, intensifying its market-share rivalry with Iran, Iraq, Angola and other OPEC members. Saudi price cuts are generally matched or beaten by those countries to stay competitive. The WSJ adds that oil traders are now watching whether non-OPEC members such as Russia join the production cuts. Russia, which produces more crude oil than any other country, is meeting with Saudi Arabia and other OPEC members next week at a conference in Istanbul to discuss potential cuts.

However, for all the talk of a cut, so far there is not even a vague outline of an agreement of what the revised production quotas would look like. Furthermore, as was noted previously, Iraq has suddenly emerged as a stumbling block, demanding that OPEC abide by its own output calculations, and not those of Argus, which vary by roughly 300 thousand barrels.

Another factor that pushed Saudi Arabia to grant Iran an exemption was that two years of low oil prices had begun imposing a sharp economic toll on ordinary Saudi citizens who had grown accustomed to a subsidized lifestyle. Saudi Arabia also needed money to continue pressing its war on its southern border with Yemen. The economic pain materialized not only in the record drop in the largest Saudi Commercial Bank...


... but also pressing market bets that Saudi Arabia will be forced to devalue its currency, an admission of economic defeat.


There are other consideration as well: "Falih wanted to make OPEC relevant again and feared the cartel could collapse without at least a show of action this year. He met with Prince Mohammed to consult about the meeting in Algiers, the people said. Falih was given the green light to make this happen by Mohammed bin Salman,” said a person familiar with the matter. They “really wanted a deal or at least the framework of a deal.”

But is there really a deal?

For all the bluster, the deal struck in Algiers could - and likely will - fall apart. The WSJ reminds us that OPEC has a long history of agreeing to production cuts, only to have the pact collapse when countries change their minds. Iran is trying to increase production, not reduce it, and so are OPEC members Nigeria and Libya, where security problems have cut off output.

Also, as Citi noted above, should the price of oil rise too high, it would help American shale producers, who could in turn help sink oil prices with new output. A U.S.-based oil boom caused the oil-price crash, and the flood of new crude helped shape the so-called Saudi market-share strategy. Saudi output cuts would only help American producers, Saudi officials have said, so the kingdom would pump up its own output and compete at low prices.

Robin Mills, chief executive at Qamar Energy, a Dubai consulting firm, said Saudi Arabia appeared to be just tweaking its strategy, aiming it less at the U.S. and more at OPEC competitors such as Iran.


“I would see it as a definite move away from the market-share strategy in terms of OPEC vs non-OPEC,” Mr. Mills said. “But within OPEC, it’s a continuation of the market-share strategy, at least aiming to prevent Iran from taking much more market share from Saudi Arabia.”

In the end, however, the decision will be up to Saudi Arabia. According to the latest report by Bernstein analysts, for the OPEC deal to work, Saudi Arabia wil have to cut crude output no less than 5%. The report estimates that Saudis will shoulder bulk of production cuts w/ 500k; Iran, Libya, Nigeria will get pass. In the context of an oil market that is currently oversupplied by ~700k b/d, creeping Saudi cuts could only escalate if the true wild card for the price of oil, Chinese import demand, were to suddenly stop, which would pressure OPEC into making even more production cuts, or rather force the country that has emerged as the marginal price setter on the supply side, the Saudis, to pump even less.

Will Saudi Arabia have the discipline to keep cutting as its hated adversary across the Persian Gulf keeps pumping more, and will local political pressure demand that Saudis throw away a deal which from the a domestic perspective benefits Iran while curbing Saudi output? The answer will depend on just how deep the upcoming (if not already here) Saudi economic crisis will be. Unfortunately for the Saudi royals, at this point whichever course the kingdom picks, will be a losing one.

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