History suggests that Saudi Arabia is justified in holding the line on output, but another 100 days of $60 Brent will make action imperative.
Past has lessons for turbulent oil market
With Brent oil prices hovering around US$60 a barrel and the Arab Opec countries meeting in Abu Dhabi this week, the time is ripe to reassess production strategies.
Saudi Arabia has chosen to maintain its output levels, currently around 9.5 million barrels of oil per day. Saudi production has remained between 9-10 mbpd since 2011 and is, in fact, lower than Saudi output in 1979.
And that year is pivotal in the Saudi experience. After 1979, under the guidance of the Saudi minister of petroleum and mineral resources Zaki Yamani, Riyadh cut production in successive rounds to maintain a high oil price. The only lasting achievement was a drop in production of two-thirds over five years. Regaining desired output took a generation. The Lessons of ’79, therefore, dictate that Saudi Arabia will not cut production this time. The kingdom is holding the line, and, big picture, that is the right strategy.
In permitting low oil prices, the Saudis seek to bring the market back into equilibrium. At present, our calculation of break-even system-wide is in the $85–$100 a barrel range on a Brent basis.
The current low price could be overkill. In many ways, the present looks much like 1985, when oil prices collapsed. How did those events play out?
In 1986, non-Opec oil production growth fell by half, and turned negative in 1987. The current outlook from the US government’s Energy Information Agency (EIA) envisions a similar evolution in US supply, with supply growth around 700,000 bpd next year. The actual outcome may be much more severe.
A study released by Credit Suisse this past week shows that US independents expect capital-expenditure (Capex) cuts of one-third against production gains of 10 per cent next year. This would imply production growth of 600,000 bpd of shale liquids, and perhaps another 200,000 bpd of Gulf of Mexico deepwater projects. At the same time, history tells us that US conventional onshore production fell by 700,000 bpd in 10 months in 1986. Were this experience to repeat itself, US oil production growth would be barely positive next year and headed for a material downturn in 2016.
North American unconventionals have been almost all of net global supply growth since 2005. If unconventional growth grinds to zero and conventional growth is falling outright, the supply side heading into 2016 looks highly compromised.
Were demand growth muted, this might not matter. However, the lessons of 1986 suggest that demand growth will pick up sharply from the middle of next year and increase by 2.8 mbpd (2.9 per cent) on an annual average basis. If we extrapolate to the global marketplace, oil demand growth could well be two to four times the number currently forecast and consistent with the events of 1986.
Were this so, the oil markets will be headed into a significant squeeze in the first half of 2016. At this point, the Lessons of ‘79 would prove misleading. In 1985, when oil prices collapsed, the world had 13 mbpd of spare capacity, with 7 mpbd in Saudi Arabia alone. Opec was well-positioned to comfortably meet any increase in demand and any loss in non-Opec supply.
Today, materially all discretionary spare capacity resides in Saudi Arabia and amounts to a paltry 2 mbpd. If a swing similar to 1986 should occur, Saudi Arabia may find itself in the position of needing to run the taps full out for much of 2016. In such an event, the model would not be 1986, but rather 1979, when the world headed right back into an oil shock.
Of course, low oil prices come at a cost. Price-inelastic demand suggests that oil prices should increase more than any cut in production. A 5 per cent cut in output by Saudi Arabia should prop up prices by 10 per cent and 15 per cent. Thus, total revenues should increase even as production falls. Given that $75 a barrel Brent is still very likely below global marginal cost, Opec could enjoy a revenue increase without compromising its ability to regain market share later on. At the same time, it would soften the blows of low oil prices for non-Opec producers and reduce the risk of a catastrophic collapse in supply.
It is too early for such a call. The marginal cost of shale production remains unclear and could be lower than thought. Capex cuts have been announced, but not yet implemented. Drill rig counts are beginning to collapse in the United States, but only in the past week.
Saudi Arabia is well justified in taking a wait-and-see approach. On the other hand, another 100 days of $60 Brent could prove catastrophic to non-Opec supply. At some point, action may become necessary.
But perhaps not by the Saudis. Russia’s position is comparable to Saudi Arabia’s. Either could cut production by meaningful quantity, but the Russians need the incremental revenue more. Saudi Arabia would be right to argue that any calls for production cuts should be directed to Moscow. Opec could cut production to prop up prices and increase revenues. But for now, a better strategy would be to hang back, deflect criticism, and let events play out. If the Russians are thinking clearly, Moscow will cut first.
Steven Kopits is the managing director of Princeton Energy Advisors, providing macro oil strategies to clients in the oil and financial sectors