The lessons of 1986 tell us that the demand surge to be expected – and it is already visible – will be too much for Saudis to handle, writes Steven Kopits.
Why rising demand will determine the oil price
The Saudi oil minister Ali Al Naimi noted this week that the kingdom’s production in March reached 10.3 million barrels per day (bpd).
This is 700,000 bpd more than in December, when the kingdom announced that it would not cut production to support prices. Most of the output gain has come in just the past month.
For the kingdom to refuse a production cut is one matter. But ramping up crude supply to the market, at prices well below global marginal cost, is another. Why has Saudi Arabia chosen this strategy?
There are two competing explanations.
First, Saudi Arabia may be seeking to increase market share or to increase production to boost revenue in a low-price environment. This makes sense. From 2004 until last year, Saudi Arabia, and Opec more broadly, essentially boosted revenue without having to increase production. Prices rose regularly, even if Opec production volumes largely stagnated. Opec revenue more than tripled from 2003 to 2013, while production was up minimally, only 3 per cent from 2005 to last year.
With the rise of US shale, that world has ended. Today, if Opec wants to increase revenue it will have to do it the old-fashioned way – by increasing production. Saudi Arabia’s expanded output therefore qualifies as adaptation to new realities.
A price-driven strategy has run its course, and a volume-driven strategy is now the order of the day. Therefore, higher output is to be expected, and the 10 million bpd production target reported by the oil minister should come as no surprise. It is a clear-eyed concession to changed realities. Mr Al Naimi did not, however, disclose why Saudi production had soared 300,000 bpd above this level, other than to note that the Saudis are responding to strong export demand.
Perhaps the Saudis are trying to increase market share even further. Nevertheless, the simplest conclusion is unavoidable – the Saudis are trying to hold down prices.
Why? If the Saudis announced a cap at 10 million bpd, Brent prices would rally quickly and materially, at least $10 per barrel.
This would benefit not only Opec, but Saudi Arabia specifically.
We are left to conclude the kingdom’s decisions are non-economic, implying that they must be political.
For a political cause, we need look no further than across the Arabian Gulf to the negotiations between the P5+1 powers and Iran. By increasing output and thus holding the price of crude down, Saudi Arabia could be encouraging Iran to reach an agreement with the P5+1.
However, the market will win in the end. The data now clearly indicates that we are reprising 1986.
In that year, OECD demand soared by 5 per cent in the second quarter alone – equal to a gain of more than 4 million bpd in global demand today.
The second quarter typically sees seasonal demand growth, but in 1986 this growth was far greater than a seasonal swing would imply. If history proves a reliable guide, we should expect surging demand this quarter – hence the Saudi need to add 650,000 bpd of production in one month alone.
Demand is up sharply in India, Europe and even China – Chinese petrol inventories have been near record lows.
And this process is far from over. Demand growth outside North America will accelerate into the middle of the year.
To keep pace, Saudi Arabia will have to increase production dramatically from now to July. Another month like the last one and the kingdom will be pumping 11 million bpd, with no end of demand growth in sight.
At some point, traders will take note that a huge supply deficit is forming in international markets. And even if they do not, Saudi policy could well be exhausted by June. The kingdom will eventually reach a limit of its willingness to expand production, and Brent oil prices will rally in response.
Furthermore, prices are likely to recover before the Iranians sign the pending nuclear arms control agreement.
This might not ultimately affect the outcome of the Iran negotiations, but it is one fewer lever for those sitting across the table from the Iranians.
Back in December, it appeared that the Saudis were simply holding production in the face of surging US output. The kingdom accepted a collapse of oil prices as necessary to balance the markets.
Today, the Saudis appear willing tolerate lower prices to achieve greater sales volumes. But the lessons of 1986 tell us that the demand surge to be expected – and it is already visible – will be too much for Saudis to handle.
Saudi Arabia, as magnificent a swing producer as it remains, cannot hold back market forces indefinitely.
The kingdom cannot long maintain oil prices above market levels, but it cannot long suppress them, either.
Steven Kopits is the president of Princeton Energy Advisors in Princeton, New Jersey