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Mar 24, 2017 | 00:01 GMT

Why Saudi Arabia Must Push OPEC To Extend Production Cuts

Saudi Arabia is hoping to extend OPEC's production cuts beyond June.
(FAYEZ NURELDINE/AFP/Getty Images)
It can be difficult to separate the important from unimportant on any given day. Reflections mean to do exactly that — by thinking about what happened today, we can consider what might happen tomorrow.

When news broke on Nov. 30, 2016, that OPEC had finally agreed on a deal to cut oil production, its first since 2008, traders sent Brent crude prices leaping 9 percent to break the $50 per barrel threshold. But after the deal was implemented, and despite reduced output among OPEC and non-OPEC producers of 1.4 million to 1.5 million barrels per day, the price of Brent fell back below $50 per barrel on Wednesday.

There are a number of factors driving continuing soft prices, but OPEC members' compliance with the deal does not appear to be a significant one. This weekend in Kuwait, an OPEC committee charged with monitoring production output will meet to discuss compliance. The same meeting will also bring a key question into focus: Will OPEC members be willing to extend the deal beyond its June expiration?

Total production cuts among OPEC members rest at more than 90 percent of agreed-upon levels, with a compliance rate of about 40 percent among non-OPEC countries. Compared with previous deals, compliance levels are high. Saudi Arabia has driven the OPEC percentage up by trimming considerably more production than it had pledged. For instance, Saudi output for February averaged about 770,000 bpd less than it produced in October 2016, a 58 percent deeper cut than it had agreed to in November.

While compliance is not the driving issue, the big question will be whether Saudi Arabia will push for an extension beyond June. That's when Saudi domestic consumption generally begins to ramp up as it burns more oil to generate electricity to meet increasing demand during the hot summer months. As the de facto leader of OPEC, Saudi Arabia's intentions weigh the most when considering an extension. It has sought to mollify concerns from oil market participants that the deal will not be extended by saying that it will push for an extension if global crude inventories do not fall to their five-year averages by the time a decision is supposed to be made at OPEC's next general meeting, May 25.

Given that it is simply impossible for oil inventories to fall that much before May, an extension of the productions cuts seems inevitable. Saudi Arabia and other oil producers spent two years pummeling the oil market with a glut in supply, resulting in two years of increasing oil inventories. Although it no longer has the ability to control the price of oil, Saudi Arabia feels that market management can still result in a drawdown of supplies. But what the Saudis need in order to accomplish that goal is time.

One of the contributing factors to the recent oil price decline has been the natural seasonal fluctuation in supply. Generally, during the first few months of a year, global oil inventories increase as energy demand slips from its peaks in the summer and winter months. Later in the year, the market could go into deficit, causing sustained withdrawals from stockpiles, which right now are considerable. OPEC estimates show that among the countries in the Organization for Economic Cooperation and Development, commercial crude oil stocks exceed five-year averages by a whopping 209 million barrels, and commercial products inventories exceed the five-year average by 69 million barrels. That implies that in order to return existing inventories to the five-year mark, on average demand would have to exceed supply by 1 million bpd for roughly nine months, or 1.8 million bpd for five months. That is an achievable goal, but only with time.

This line of thinking is a powerful influence on Saudi Arabia's current strategy. If Saudi Arabia cannot hold the production cut deal together, then other producers would increase production, and Saudi Arabia would likely have to follow suit in order to meet domestic demand and also not lose its market position overseas. The market might still maintain a deficit during the summer months, but the real risk would come when demand falls again in autumn. If a production deal is not reinstated by then, oil inventories could once again swell. At that point, there would be little chance of resurrecting a supply deal in quick order. Prices, of course, would be deeply affected almost as soon as a failure to extend the deal is announced.

Riyadh knows that by and large, a swift recovery in oil prices is unlikely.

As Saudi Arabia looks to 2018, its priorities will be seeing a reversal in oil inventories and forestalling the possibility of oil prices falling back below $40. Riyadh knows that by and large, a swift recovery in oil prices is unlikely. Efficiencies have brought the marginal costs of shale oil production down to the $50 to $60 range for most U.S. plays, if not lower. This provides short- and medium-term caps on oil price increases. The fact that Saudi Arabia cannot rely on a return to higher oil prices means that its vital Vision 2030 and five-year National Transformation Program, which aim to shift the Saudi economy away from its reliance on petroleum, remain the absolute top drivers behind its economic and domestic policies. Its reform effort will rely on the initial public offering of shares of Saudi Aramco, planned for 2018. The country will use the proceeds of those sales to help pay for many of the economic reforms and finance development of the non-oil sector.

Since the Saudi Aramco deal is so vital to the future of that economic reform package, Saudi Arabia may be willing to overlook poor compliance with a production cut agreement from other participants, such as Russia, or will refrain from aggressively pushing Iran, which is exempt from the current production cut measure, to limit its production should it join the deal. But that doesn't mean Saudi Arabia will not be aggressive about trying to coerce other OPEC members to extend the production cuts. It simply cannot afford to allow the production deal to expire. Its efforts would receive a boost if other producers follow suit. Many of its Gulf Cooperation Council allies, including Kuwait, have also expressed the need to extend the deal. Additionally, many of the supply hawks within OPEC, such as Venezuela, remain supportive of an extension.

The biggest area of concern for Saudi Arabia over oil production remains compliance by Russia. The country had agreed to trim production over time to reach 300,000 bpd, the second-highest figure by any producer in the deal, and although it has not yet hit that mark, it is ahead of schedule in implementing cuts. That said, the lion's share of Russia's cuts have been shouldered by Rosneft, which alone has trimmed output by 83,000 bpd, representing roughly two-thirds of Russia's cuts in production.

Rosneft has consistently lobbied for Russia not to be involved in any agreements and earlier this month noted that it had concerns about extending the deal because other of the country's producers have not fulfilled their promises. This is likely a message from the oil giant's chief, Igor Sechin, aimed squarely at rival Russian producers, warning them to get on board because Rosneft will not increase its share. Rosneft is likely leveraging its participation in the cuts to exact concessions from the Kremlin on a string of other issues (such as taxes and assets control). Should Rosneft oppose extending the deal, Russia's overall involvement would decline entirely. If Russian participation wanes, it would be a huge blow to Riyadh, which is competing with Russia for market share in places such as China.

Nevertheless, it is clear what Saudi Arabia's optimal outcome is. Saudi Energy Minister Khalid al-Falih has his work cut out for him over the next two months as he strives to extend the production cut deal in the face all of its complications.

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