Over the past month OPEC nations and Russia have become increasingly vocal over their concern with the global glut of oil that has led prices to thirteen-year-lows. Financial headlines were consumed with news out of Russia late last month alleging that Russia and OPEC nations were in talks to coordinate a production cut, which led oil prices to rally higher. As the reports faded, prices once again tumbled lower, but just as WTI crude prices were making new record-lows for the year on Thursday and testing a key support level, headlines once again became consumed with claims from a UAE Energy Minister that OPEC members might be ready to cooperate on curtailing production. This led prices on Friday to surge by the most in a single day since 2009. This morning, news broke that Russia, Saudi Arabia, Venezuela, and Qatar have agreed to not exceed last month’s production levels, but this is far cry from announcing a production cut. To understand what OPEC might do next, we must first consider how we got here in the first place, and it is not quite as simple as headlines would lead you to believe.
Historically, OPEC and Saudi Arabia (which accounts for over 30% of total OPEC production) worked to balance the global supply of oil. They sought to coordinate a maximum level of output, so as to prevent a situation where oil supplies increased enough to cause oil prices to fall below a range that is profitable for the cartel’s producing nations. This strategy of price stability had worked relatively well for a number of years, that is, until the U.S. shale oil revolution and Russia began cutting into their market share. As a result, in late summer 2014, oil supply data began to reveal a new trend; OPEC (read Saudi Arabia) was no longer limiting production output to balance global markets. Prices then began to fall, and by OPEC’s yearly meeting in November 2014, it was already evident to those paying close attention to the data that this was not just an anomaly but a deliberate action.
This moment served to officially demarcate a historic change in OPEC strategy, one that sought to defend their global market share rather than to steady prices. In short, the hope was to drive out “high-cost” (read OECD/US shale and Russian) production so as to reduce the supply and allow prices to rise once they had pushed out their competition.
A year-and-a-half later three things are abundantly clear:
1. OPEC underestimated the resiliency of U.S. production:
Shale producers in the U.S. slashed budgets, focused on their most prolific and lowest cost wells, and worked vigorously to become more efficient, allowing their breakeven prices to be significantly reduced and production to remain resilient. As a result, OECD production is relatively unchanged over the past year, between 26 and 27 million barrels per day, despite prices falling over 70%.
2. “OPEC’s” new policy was largely just Saudi Arabian policy:
Saudi Arabia, being the leading producer and most influential OPEC member, had likely reflected on history to develop their strategy. The last time Saudi Arabia had significantly cut production to try and clear a major glut in the 1980’s, prices failed to recover quickly, and they wound up losing both market share and revenues. Saudi Arabia knows that when it has historically curtailed production other smaller volume and higher cost producers within OPEC cheat and do not actually limit their output. This time around however, Saudi Arabia had even more to lose by cutting production in early 2015, as they were in the midst of a competitive struggle for Chinese market share with Russia.
3. Saudi Arabia, oil analysts, and economists vastly underestimated the importance of foreign exchange rates and monetary policy in forecasting break-even prices:
Forecasts throughout 2015 for potential low price scenarios were largely based on break-even costs, and in nations like Russia and Saudi Arabia which use oil revenues for a large portion of their government budgets, what is considered a “fiscal” break-even cost. And while it is true that nations like Russia and Saudi Arabia both use oil revenues as a primary source of funding for government budgets, there is one monumental difference between these two nations that analysts and economists from OPEC to the IMF underestimated.
As the Federal Reserve concluded its quantitative easing program and began planning for interest rate hikes in late 2014, the Bank of Russia ended the ruble’s peg to the U.S. dollar on expectations for the U.S. dollar to continue to appreciate. This meant the Russian ruble would float, allowing market forces to determine the exchange rate rather than central bank intervention, and as oil prices collapsed, so did the value of the Russian ruble against the U.S. dollar. But because oil is U.S. dollar denominated, despite oil prices plunging lower in terms of U.S. dollars, Russian rouble-denominated oil revenues were largely unchanged. Saudi Arabia on the other hand kept their U.S. dollar peg, and as a result of a strong U.S. dollar and plummeting oil prices their revenues were decimated, leading the country to burn through roughly $100 billion in foreign-exchange reserves in 2015. To make matters worse, Russia steadily chipped away at Saudi Arabia’s market share in China throughout 2015, as Chinese imports from Saudi Arabia increased only 2.1 percent to 46.08 million metric tons, while imports from Russia increased 28 percent to 37.62 million.
With the past year’s events fully understood and in context we can now make a more sound evaluation of what Saudi Arabia and OPEC might do next. So, could Saudi Arabia actually limit production? Although it is improbable, of course they could. But as economists we have a duty to examine the incentives that would lead them to act, and if they do act, how that might change the actions of their competitors. Given that its goal of forcing out competition has been a complete failure so far, capitulating on their strategy at this point would have meant forfeiting billions of dollars in vain. Couple this with the realization that both smaller OPEC (especially their geopolitical adversary Iran) and non-OPEC producers are likely to increase output if Saudi Arabia agrees to curtail production, and you can see why even if they were to agree to a cut, the global supply would remain above where the Saudis want it to be.
The agreement announced today between Saudi Arabia, Russia, Qatar, and Venezuela to not exceed January’s production levels, but not cut production, is just more of the same symbolic gestures we have seen reported in recent weeks. This announcement comes at a time when Russia is producing at post-Soviet era highs and was already expected to have relatively flat production over the coming year, meaning this “freeze” does little for supply and demand balance expectations. In the long-term there seems to be only two likely options left for Saudi Arabia; continue the current path in hopes that their competition begins to close in production or (what is in my view most likely) break the U.S. dollar peg and allow the Saudi riyal to float like the Russian ruble. Seeing as Saudi Arabia has over $600 billion in foreign reserves, and their largest competitor for Asian market share is Russia and not the U.S., strategically both options are more beneficial than cutting production at this time.
