After two years, why an OPEC deal now? Kemp

By John Kemp

OPEC has finally agreed to cut production, but only after two years of fruitless negotiations. So what changed to make an agreement possible now, after it had eluded negotiators at previous OPEC meetings?

The intense diplomatic maneuvering behind the deal has been capably chronicled by my colleagues at Reuters (“How Putin, Khamenei and Saudi prince got OPEC deal done”), Bloomberg (“OPEC deal hinged on 2 a.m. phone call and it nearly failed”) and the Financial Times (“Saudi prince’s ambition for life beyond oil forces OPEC deal”).

The common theme in these accounts is the personal intervention of top political leaders, which overcame the obstacles which had stalled negotiations at technical level (“OPEC talks struggle with question of market share”, Reuters, Nov 24).

But the context was a change in oil market conditions that made it more attractive for Saudi Arabia and other members of the Organization of the Petroleum Exporting Countries to reach a deal. For the first time since 2014, the kingdom can afford to cut output without too much risk that other producers would fill the gap by raising their output in the near term.

The signal for the November 2016 agreement came when Iran was no longer able to increase its oil production further over the summer. Saudi officials have long stated that it would only be possible to reach an OPEC agreement once Iran had normalized its output following the lifting of sanctions.

SAUDI SHIFT

Saudi Arabia, the organization’s most influential member, has been seen as relatively unenthusiastic about a deal until the last few months.

But Saudi Arabia’s veteran oil minister Ali al-Naimi, seen as a skeptic, was replaced by Khalid al-Falih in May, who has been more sympathetic to exploring the opportunities for an agreement.

The Saudi economy has also continued to deteriorate, with a substantial increase in unpaid government and business bills, and a further fall in foreign reserves, all of which increased pressure for a deal.

And the kingdom’s “Vision 2030” economic transformation program and planned share offering in the national oil company, announced in 2016, both depend for their success on higher oil prices.

Saudi Arabia’s willingness to strike a deal shifted at some point between the unsuccessful OPEC meeting held in June 2016 and the successful OPEC meeting held in September 2016.

By September, Saudi negotiators went to OPEC’s meeting in Algiers eager to reach a deal and willing to show sufficient flexibility to get one done.

The provisional agreement concluded in Algiers was then turned into a final accord in Vienna this week (“Saudi brinkmanship aims to re-establish leverage within OPEC”, Reuters, Nov. 28).

INDISPENSABLE NATION

Saudi Arabia is not like other members of OPEC. Saudi Arabia has always been the indispensable nation without which no agreement is possible.

“Saudi Arabia is more influential than other OPEC members,” wrote Anas Alhajji and David Huettner in what remains the classic short study of the organization (“OPEC and other commodity cartels”, 2000).

“Saudi Arabia meets all the characteristics of a dominant producer by having relatively large market share, excess capacity, flexible behavior (and) the ability to move its price by increasing or decreasing production.”

“No other OPEC member has similar behavior. Therefore Saudi Arabia should be treated on its own within OPEC,” they concluded.

“Some of the confusion surrounding OPEC behavior has been caused by mistakenly assigning the power of Saudi Arabia, along with its Gulf allies, to OPEC (as a whole).”

MARKET SHARE

Saudi officials have stated consistently the kingdom will not sacrifice market share to other producers – whether U.S. shale firms, OPEC rivals such as Iran and Iraq, or non-OPEC competitors such as Russia.

Saudi officials refused to cut output during 2014 and 2015 for fear that any price increase would simply throw a lifeline to U.S. shale firms and encourage them to raise their production. Since May 2015, however, U.S. oil production has been falling, eliminating one source of competition.

Saudi Arabia continued to refuse to cut output during 2015 and the first half of 2016, citing the threat of increased production from Iraq, Iran and Russia. But by the summer of 2016, Iranian output appeared to have reached a temporary plateau following the lifting of sanctions, reducing the threat from that quarter.

The main challenge to Saudi market share now comes from Iraq and Russia, both of which have increased their output this year. But Saudi officials may have concluded the scope for further increases in the short term was modest and that an agreement to freeze Iraq’s and Russia’s output around current levels would be viable.

MARKET POWER

Saudi officials have usually assumed, with justification, that other OPEC and non-OPEC members will cheat on any production agreement if they can. But sometimes other OPEC and non-OPEC countries are unable to cheat because of war, sanctions, social unrest or lack of investment, which makes deals possible.

Between 2014 and 2016, Saudi Arabia had no incentive to cut production because other countries were likely to respond by increasing their own output. Riyadh would have been left with lower output and unchanged or lower prices, resulting in lower revenues. Output cuts were not an optimal strategy for the Saudis.

But with Iran’s output apparently peaking in the summer of 2016, opportunities for cheating have become more limited. Most other OPEC members are struggling to maintain current production and have few options to raise output.

The main challenge comes from further increases in output from Iraq and Russia, and both countries have agreed to freeze or cut their output under the November agreement. Given output from other sources is now maximized or frozen, Saudi Arabia’s optimal strategy is to reduce output and secure an increase in prices.

1999 OUTPUT DEAL

The circumstances for an output deal are somewhat similar to those which facilitated the successful output-cutting deal of March 1999 between OPEC and certain non-OPEC countries.

“Lower capacity prevented OPEC members from cheating and prevented non-OPEC members from increasing their production,” after March 1999, Alhajji and Huettner explained shortly afterwards.

“The only country that reduced production voluntarily …. was Saudi Arabia, with marginal help from Kuwait and the UAE, while all other oil producing countries were forced to reduce their production because of technical, political or natural factors,” they said.

“The reason for the success of the March (1999) agreement, which included non-OPEC members such as Mexico, Oman, Norway and Russia, despite the failure of all prior agreements since 1984 in lifting prices is the inability of many countries to produce more oil.”

Production cuts are made by Saudi Arabia and its allies, rather than by OPEC as a whole, or by OPEC and non-OPEC.

SELF INTEREST

Saudi Arabia and its allies only cut output when they are confident other OPEC and non-OPEC members have limited capacity to cheat.

These conditions occurred in March 1999 and again in November 2016, which is why Saudi Arabia and its allies have been willing to agree to a production cutting deal.

While the current deal contains commitments to production cuts or freezes from other OPEC and non-OPEC members, and a verification mechanism, it does not really depend on them to be effective.

From a Saudi perspective, the important consideration is that Iran cannot increase its output much further, and that Iraq and Russia have committed to freezing if not actually reducing their output.

In the next year, the main threat to the deal comes from U.S. shale as well as from Iraq and Russia. The deal can survive some degree of “slippage” from shale and other OPEC and non-OPEC producers because consumption is growing, which will help absorb some non-compliance as well as a limited shale revival.

But if rival producers start increasing their output significantly, maintaining output cuts will no longer be optimal and Riyadh will adjust its strategy accordingly.

Until then, Saudi Arabia is acting in its own interest by cutting production, even if other OPEC and non-OPEC producers fail to follow through fully on their commitments.

(Editing by Susan Thomas and David Evans)