Output Cut is a Temporary Reprieve
OPEC has agreed to reduce current production levels in the first such move since the 2008 global financial crisis. The deal marks a major reversal of the “free-for-all” market-share strategy that Saudi Arabia and other Gulf Arab states have adopted in recent years as they sought to drive down prices and undermine US shale producers. However, there are reasons to doubt that the agreement will hold, not least because of weak enforcement mechanisms and the prospect of rising US shale production should prices rise significantly, which have so far averaged at US$45/barrel in 2016.
The response to the deal from the markets has been vigorous, although it was largely psychological, driven by speculative activity and paper—rather than physical—trading. The price for Brent crude futures—the international benchmark for oil prices—soared by nearly 9% to over US$50/barrel. Other major producers outside of the cartel, including Russia, have also agreed to trim their output by 600,000 barrels/day (b/d), the details of how it will be achieved are scant though. In any case, effective January 2017, the oil cartel, which pumps one‑third of global oil output, will trim its current output level by 1.2 million b/d to 32.5 million b/d for six months (January-June). Whether the accord will be rolled over for another six months largely depends on whether the agreement translates into sustained higher prices.
There has been a sharp impact of the Opec-non-Opec producers’ move on Indian oil prices. The Indian basket of crude oils gained more than US$3 a barrel at US$54.42 per barrel over the weekend of December 11-12, even as global prices surged to an 18-month high. The price on December 21, was US$53.47 (INR 3,629), compared with US$50.85 (INR 3,460.34) per barrel on November 29. Oil prices had fallen more than 50 percent in the past two years, from around US $120 a barrel.
Saudi concedes
Although OPEC’s ability to set prices has weakened considerably with the rise of US shale, the deal demonstrates that the cartel can still exert some market influence. This was not easy to achieve, given divergent views within the organisation over who should bear the brunt of any cuts. In particular, Saudi Arabia, Iran and Iraq have been at loggerheads for a long time over how the cuts should be apportioned. Iran claims the right to return to levels prior to stringent international sanctions introduced in 2012, and Iraq maintains that it needs to finance a costly war against the jihadi Islamic State group.
With this in mind, Saudi Arabia has agreed to shoulder much of the burden and to reduce its output by 486,000 b/d to 10 million b/d. This was largely expected, as Saudi Arabia was the main beneficiary from the imposition of international sanctions on Iran, which enabled the kingdom to boost its output by 2 million b/d since 2011. Following Saudi Arabia’s lead, other Gulf Arab states—namely Kuwait, Qatar and the UAE—have also said that they will scale back production by 300,000 b/d, with the remaining cuts to be distributed among the other members of the cartel. Oman, the largest non-OPEC producer in the Middle East, has been critical of OPEC’s previous push for market share and would be likely to approve the suggested cuts, given its external and fiscal dependence on oil revenue. Meanwhile, Iran has agreed to freeze its output at 3.8m b/d, and Iraq has accepted a cut of 210,000 b/d to 4.35m b/d. Exemptions have been made for war-torn Libya and Nigeria, whose economies have suffered the most as a result of armed conflict. A breakdown of the new OPEC quota shows that a cut of around 4.5% will be applied across all of OPEC’s members—with the notable exceptions of Libya and Nigeria.
Good news for shale
Perhaps more crucial, the response from US shale producers will determine the longevity of the OPEC agreement. After surging from around 7 million b/d in 2008 to a peak of 13 million b/d in April 2015, on the back of a boom in shale output, US oil production fell to 12.1 million b/d in August 2016 as persistently low prices prevented cash-strapped and indebted shale producers from making the necessary investments to sustain output. However, OPEC members will be aware that even a small recovery in prices will incentivise the US oil industry, which has shown some resilience over the past two years. Shale producers have adapted their technologies to reduce production costs.
Meanwhile, India, the third-largest oil consumer in the world, which imports over 80 per cent of its oil, has unveiled a new revenue-sharing regime to explore for more hydrocarbons. Forty-two oil companies have submitted 134 e-bids to explore 67 small fields and produce hydrocarbons, if found, on a new revenue-sharing basis, instead of cost-and-output-based, or production-sharing, model, as practiced earlier.
