By Nick Cunningham
OPEC is struggling with a floundering oil market, few prospects of higher oil prices, competition from U.S. shale, and dissension within its own ranks. The supply/demand situation is improving, but at a painfully slow pace.
OPEC will meet again in a few days to try to figure out how to boost compliance with the collective cuts, but the group is faced with no good options in trying to balance the market.
The prospect of deeper cuts has been floated, but the risk is that it would require more sacrifice with an uncertain payoff. In any event, OPEC appears to be struggling with maintaining compliance for its existing cuts. Although some dispute the data, it appears that more than half of the participating OPEC members are not fully complying with their obligations. Worse, Nigeria and Libya, exempted from the deal, are boosting output. OPEC production actually jumped in July by 90,000 bpd, according to a Reuters survey, putting collective output at its highest point so far this year.
In the past, OPEC has fine-tuned its output levels over time, making multiple cuts in response to market conditions. That makes the current deal, consisting of one cut that has been extended, atypical. History suggests OPEC could simply follow up with a deeper reduction in order to boost prices.
But OPEC no longer has that luxury. Unlike in the past, the group can no longer afford to ride out an extended period of low prices. In the 1980s when the group abandoned any sense of cooperation and produced at maximum capacity, it crashed oil prices for years, a downturn that arguably extended until the beginning of the 21st century (aside from a temporary period of time during the Persian Gulf War). That downturn worked in the sense that U.S. oil production went into a long-term decline that many thought would be terminal.
OPEC can no longer afford to ride out a wave of low oil prices that could last upwards of a decade or more in order to kill off rival production from places like the United States. That is because the major oil producers of the Middle East have dramatically higher spending levels than they did in the past. Ever since the Arab Spring, which saw widespread discontent and instability spread throughout the region, Saudi Arabia and other Gulf States had to shower their populaces in social spending in order to stave off rebellion. So, while they still have some of the lowest oil production costs in the world – costing just a few dollars to produce a barrel of oil – the real costs come from the broader government budget.
For example, the WSJ notes that the UAE can produce oil for about $12 per barrel, but it actually needs something like $67 per barrel to balance its budget – a fiscal breakeven price far above the prevailing market price for the last three years. But the UAE is far from the worst off. A report from Fitch from earlier this year, and reported on by Bloomberg, laid out fiscal breakeven prices for oil-producing countries:
• Nigeria at $139
• Bahrain at $84
• Angola at $82
• Oman at $75
• Saudi Arabia at $74
• Russia at $72
• Kazakhstan at $71
• Gabon at $66
• Azerbaijan at $66
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• Iraq at $61
• Abu Dhabi, United Arab Emirates, at $60
• Republic of Congo at $52
• Qatar at $51
• Kuwait at $45
There are several important points from figures like these. First, it explains why compliance with the promised OPEC cuts has been slipping. Financial pressure on countries like Iraq and the UAE incentivize cheating. Ecuador calculated that it could no longer stick to its reductions and decided to abandon the OPEC agreement a few weeks ago. The WSJ says that 7 out of the 11 participating members are not fully complying.
More importantly, however, is that many OPEC members are now running budget deficits. For decades, the Gulf States had huge surpluses, but painful fiscal shortfalls now mean that OPEC cannot tolerate low oil prices forever. Many major Middle Eastern producers have had to make painful cuts to spending, an austerity campaign that has hit growth in the region.
All of that is to say that OPEC probably does not have the appetite for deeper cuts. The only way they would cut deeper is if they were confident that oil prices would rise substantially, a highly uncertain prospect in today’s market.
The more likely scenario is that they keep the current reductions through March 2018, and Saudi Arabia will try to browbeat its peers into keeping compliance high. It is not a great situation for the group to be in. “OPEC will have lot of difficulties to respect its commitments because of budgetary difficulties faced by some its member countries,” Chakib Khelil, the former oil minister of Algeria, told the WSJ.
If oil prices do not rise, the longer-term prospects are even darker. OPEC has no “exit strategy” in mind next year. Again, just as there is little to no appetite for deeper cuts, there is probably not a lot of excitement within OPEC to extend the deal again beyond the first quarter of 2018. That raises the prospect of returning to full production, a scenario that could cause prices to crash once again.
The possibility of oil prices remaining around $50 per barrel or lower for years to come is a serious threat to the financial health of many oil-producing countries. The ongoing implosion of Venezuela is largely an outgrowth of low oil prices.
Producers in the Middle East have a lot more financial firepower to work with, but they cannot hold on forever. More instability in more countries is likely. The WSJ notes that Saudi Arabia has burned through about $246 billion in cash reserves since 2014 while also turning to the debt markets. “We calculate, and a lot of people we know calculate, there’s about three more years of this they could deal with, with regard to drawdowns in the sovereign funds—and then they’ve got a very severe problem,” Tim Dove, CEO of Pioneer Natural Resources Co., told the WSJ.
By Nick Cunningham of Oilprice.com