Saudi Arabia prefers higher oil prices to higher production volumes
Much to the surprise of the analyst community, on Wednesday in Algiers Opec reached a potentially historic deal calling for broad-based oil production cuts. The deal as proposed by the Algerian team before the meeting called for reductions of 800,000 barrels per day compared to the levels prevailing this past August. The final communique indicated a broad range of reductions, 200,000 to 700,000 bpd, with details to be hammered out at the November Opec meeting.
The deal was immediately panned by most of the investment banking community. They decried its lack of specifics, the absence of a timetable, and questioned the base month of the cuts. A number of analysts felt Opec was “kicking the can down the road”. They questioned whether unrestricted production gains for Nigeria and Libya undermined the transaction, and whether the Iranians would ultimately accept only a small production gain.
All these criticisms are valid and they may yet undermine a deal in the end. But that’s not the relevant question. The real question is whether Saudi Arabia truly wants production cuts and is prepared to contribute at least pro rata to these cuts. If Saudi Arabia is willing to lead, then others are likely to follow.
Saudi rhetoric suggests the kingdom is committed. On Tuesday, the Saudi energy minister Khalid Al Falih allowed that any deal would involve Iran, Nigeria and Libya producing “at maximum levels that make sense”, according to a Reuters report. This is a remarkable turnabout for the Saudis, who up until the meeting were pushing for an Iranian production freeze as a condition of any agreement. Given the recent tensions between Riyadh and Tehran, the concession was a complete surprise. That the Saudis volunteered it strongly suggests they are serious about closing a deal.
But why now? What has changed for the Saudis?
Saudi fiscal pressures are acute, and most analysts have attributed the change of heart primarily to the kingdom’s fiscal challenges. In the past few years, oil revenues have constituted as much as 90 per cent of the government budget. As a result, Saudi finances are dependent on oil prices. When those are high, life is good. When prices are low, as they are now, the kingdom is under stiff pressure to adjust. The IMF forecasts the 2016 budget deficit at an unsustainable 13.5 per cent of GDP.
If prices do not recover, Saudi Arabia will have to either continue to run up debt or consume reserves at the pace of perhaps 10 per cent of GDP per year. Saudi Arabia certainly has capacity to increase borrowing and no doubt will. In the absence of meaningful oil price recovery, however, this strategy has a finite shelf life. The country will also have to reduce spending. At current oil prices, the kingdom will face pressure to reduce government expenditures by around $2,000 per capita over the next three years or so, a challenge both in terms of policy and politics. Thus, Saudi Arabia has every incentive for higher oil prices.
Still, how strong is the motivation in reality? Every $4 per barrel oil price increase raises Saudi revenues by about $1 billion per month. OPEC cuts are anticipated to raise oil prices by $5-$10 per barrel, equating to perhaps $14 bn per year for the kingdom, net of production cuts. This is helpful, but does not come even close to closing the Saudi budget gap, which we estimate at $84bn for 2016.
Is there some other motivation? We believe there is.
Saudi Arabia has been pumping at historically high levels in recent times, near 10.6 million bpd in recent months.
Nevertheless, it has been selling even more. Since January, the kingdom has been selling about 200,000 barrels more per day than it has been producing. As a result, crude inventories have declined, and have reverted close to optimal levels. Indeed, we now see backwardation in some product categories in Dubai. Demand is beginning to run ahead of supply.
Under the circumstances, Saudi Arabia lacks much motivation to maintain recent sales levels. Why should it run down inventories to uncomfortable levels at current weak prices? It would make more sense to curtail sales modestly and stabilise inventories.
Alternatively, the kingdom could call on its spare capacity, estimated at a thin 1 million bpd (with this largely the entire dispatchable capacity worldwide). Historically, the Saudis have avoided running flat out, and spare capacity at the edges often comes at a cost. Meanwhile, Saudi Arabia has no major expansion projects in the works through year-end 2017. The Neutral Zone between Kuwait and Saudi Arabia is anticipated to come back on line perhaps late next year, but does not provide meaningful reserves in the short run. Consequently, Saudi Arabia appears largely tapped out, and indeed has been running its fields hard. A desire to ease back production by a few hundred thousand barrels per day would come as no surprise. The Saudis may actually desire production cuts, regardless of a deal.
Thus, Saudi Arabia has both fiscal and oil sector reasons to prefer higher prices to higher oil production volumes. The country’s capacity is largely committed and sales have been running ahead of production, even as budget realities compel the government to adjust social spending down. We believe these realities are driving Saudi attitudes, and as a result, the Saudi offer is genuine. The kingdom will do what it takes to secure a deal in November.
Steven Kopits is the president of Princeton Energy Advisors in New Jersey
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Published: September 29, 2016 04:00 AM