21 February 2019, News Wires — Saudi Arabia has resumed its traditional role as the swing producer, sharply reducing its own output to tighten the oil market and push prices higher.
The de facto OPEC leader has demonstrated, once again, that it can always tighten the physical market, boost prices and push the calendar spread into backwardation – if it is prepared to cut its own production enough.
The familiar problem is that protecting prices comes at the expense of market share: the more the kingdom cuts its own production and tightens the market, the more it encourages increased output from other sources.
In this case, rising prices threaten to extend the oil drilling and production boom in the United States, which would ultimately force Saudi Arabia to make even deeper cuts or abandon its price-defence strategy.
Saudi Arabia has never been able to escape from this dilemma and the country’s oil policy has cycled between a priority on price defence and volume defence.
The kingdom has always struggled to craft an exit strategy from periods of output restraint. Policymakers pursue production curbs for too long, tighten the market too much and drive prices to an unsustainable level.
The result is usually a slowdown in consumption growth and an acceleration of non-Saudi sources of production that pushes the market back towards surplus and necessitates a new round of output cuts.
The kingdom made the same mistake in 2008, 2014 and 2018, failing to raise production early enough, creating the conditions for unsustainable price inflation and sowing the seeds of the subsequent downturns.
Like any oil exporter Saudi Arabia will always benefit from an increase in prices in the short term, but it can then prove difficult to put a lid on the market.
Saudi Arabia’s informal price targets tend to ratchet up as realised prices rise, with its targets tending to be somewhat elastic.
In the first nine months of 2018 Saudi Arabia allowed the market to tighten too much, pushing prices above $80. That proved unsustainable and triggered a slowdown in consumption growth and a surge in U.S. shale.
The question is whether the Saudis will make the same mistake again in 2019. Experience suggests it will.
Senior Saudi officials have often sought to downplay the swing-producer tag since the mid-1980s, when the kingdom cut production even as other countries raised theirs.
They have been keen to emphasise the importance of spreading cuts across Organization of the Petroleum Exporting Countries (OPEC) and more recently an enlarged group including Russia and Oman (OPEC+).
But the historical record shows that cuts by Saudi Arabia have been decisive in influencing spot prices and calendar spreads, and that Saudi Arabia, rather than OPEC or OPEC+, is the true swing producer.
By cutting its own production, Saudi Arabia has always been able to engineer a rise in Brent spot prices and push the calendar spread into backwardation, as the attached charts illustrate.
The kingdom’s influence is enhanced when the global oil economy and oil consumption are growing strongly and when the output of rival producers is disrupted by war, sanctions or civil unrest.
Saudi Arabia has preferred to assemble coalitions of other producers to maximise its price leverage and for diplomatic reasons (OPEC and OPEC+ provide a useful shield against international criticism).
But Saudi output policy has been the primary driver of market prices and spreads as the kingdom has been the only exporter with the scale and flexibility to shift the global production-consumption balance.
The recent round of production cuts, agreed by OPEC+ at the start of December, has conformed to this pattern (“The 5th OPEC and non-OPEC ministerial meeting concludes”, OPEC, Dec. 7).
The enlarged group agreed to cut by a total of 1.2 million barrels per day (bpd) in the first six months of 2019, with reductions to be shared between OPEC (0.8 million bpd) and its Russia-led allies (0.4 million bpd).
In the event, Saudi Arabia cut its own output by 380,000 million bpd in January, exceeding its pledged share of 320,000 bpd and accounting for more than half of the total cuts achieved by OPEC in the first month.
Saudi Arabia’s aggressive reductions have compensated for poor compliance with the agreement by some other OPEC and OPEC+ members (“OPEC oil output falls by 890,000 bpd in January”, Reuters, Jan. 31).
The kingdom has gone further and pledged to reduce its output by more than 1 million bpd from 11 million-plus in November to only 9.8 million in March, Oil Minister Khalid al-Falih said in a recent interview with the Financial Times.
The kingdom’s shift has helped to boost front-month Brent futures prices by more than $15 a barrel (30 percent) since late December and push the six-month calendar spread from a $1.70 contango to 45 cent backwardation.
The price impact has been assisted by increased optimism that the global economy will avert recession as well as the impact of U.S. sanctions on Venezuela’s oil production and position-building by hedge funds.
PLUS CA CHANGE
Provided that the global economy avoids recession or a prolonged slowdown this year, the oil market will tighten progressively over the course of 2019.
Given their approach last year, Saudi Arabia and OPEC+ are likely to prolong their output restraint until prices are well above $70, perhaps breaching $80.
The result will be another spurt of U.S. shale production and a slowdown in oil consumption growth, pushing the market back towards surplus and necessitating another round of cuts.
If Saudi Arabia and OPEC+ want to halt this cycle of instability, they need to be pro-active and start relaxing output curbs gradually as prices climb above $70.
But OPEC has never been great at fine-tuning and the track record suggests prices are likely to overshoot on the upside to set the cycle in motion all over again.