Af­ter two years, why an OPEC deal now?

Kuwait Times - - BUSINESS -

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 ma­noeu­vring 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 am 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.

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 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 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 Michael Huet­tner in what re­mains the classic short study of the or­ga­ni­za­tion.

“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 US 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 US shale firms and en­cour­age them to raise their pro­duc­tion. Since May 2015, how­ever, US 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. —Reuters

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