London — Saudi Arabia and its allies in the expanded OPEC+ group of oil-exporting nations have successfully engineered a prospective deficit in the oil market, boosting spot prices and calendar spreads over the last four weeks.
Front-month Brent futures prices have risen by more than $15 per barrel (80%) since the second trimester of April, while the six-month calendar spread has tightened from more than $12 contango to less than $3.
The unprecedented scale of the production cuts announced by Saudi Arabia and its allies last month, and signs of strong compliance from many countries, including Russia, have attracted a lot of comment.
But experience suggests Saudi Arabia and its allies in OPEC and OPEC+ have always been able to force the market into deficit, boosting prices and spreads, when they wanted to do so, so it should not have come as a surprise.
The producer group, with a rotating cast of members, but always led by Saudi Arabia, successfully engineered deficits in 1998/99, 2001/02, 2006/07, 2008/09, 2016/17 and 2019/2020.
The recent production-cutting agreement, announced on April 9, and the subsequent response of spot prices and spreads, have fitted the pattern perfectly.
Most commentary focuses on the top-level diplomacy and personalities involved in production-cutting agreements.
But a more structural approach that focuses on the financial costs and incentives that lie behind each deal shows a recurring pattern.
Readiness To Act
The question has never been the producer group’s ability to engineer deficits by cutting its own output sufficiently but its readiness to do so.
Saudi Arabia’s participation, as the world’s largest crude exporter, and the only country normally willing to flex production significantly, has been essential.
Saudi Arabia must be willing to cut to its own output deeply and be able to enlist sufficient cooperation from other exporters as a precondition for being willing to do so.
In each case, a successful production-cutting agreement was preceded by a sharp decline in the kingdom’s crude export revenues, which ensured its top policymakers were keen on reaching a deal.
Slumping export earnings have ensured it is in the kingdom’s self-interest to cut output, provided it can be reasonably sure other exporters will not step into the resulting supply gap, at least in the short term.
The kingdom does not disclose exact crude export earnings but they can be estimated, very roughly, from its recorded export volumes and average Brent prices.
In the recent case, the kingdom’s crude export earnings shrank to less than $280 million per day in March, down from almost $400 million per day in February, and $480 million per day in March 2019. Revenues almost certainly much further in April.
Tumbling export earnings lay behind the sharp drop in the kingdom’s foreign reserves in March and its subsequent announcement of tax rises and spending cuts.
They also concentrated the minds of senior policymakers on the costs of fighting a volume war for market share in the middle of a pandemic.
The collapse in export earnings was similar in magnitude to 2009 and 2016, and seems to have prompted a similar readiness to reach a new production agreement.
Once Russia and the United States could be brought on board to provide diplomatic cover and ensure output cuts would not be offset immediately, the kingdom’s self-interest dictated it reach a deal.