Article10 Jun 2015

Is It Time to Write OPEC’s Obituary?

Citi GPS Opinion Article
OPEC’s obituary has been prematurely written several times. But discounting a strong future for the oil producer organization, often incorrectly referred to as a cartel, seems more logical today than at perhaps any other point in the group’s 55-year history.

s oil market, it seemed to be asserting that the institution had lost its purpose. The Kingdom, the group’s largest producer by an order of magnitude, proclaimed that it would no longer provide additional or less liquidity to markets by raising or lowering its production to meet its own, and the producer group’s, price objectives. Rather, by ending its decades-long practice of being a swing producer and leading the rest of the producer group in the implementation of its price goals, the Kingdom was going to maximize its own market share.

What has confused markets as well as other producing countries, both inside OPEC and outside of it, is a combination of questions. Why had OPEC’s largest producer decided to adopt a market share strategy? Why then? And for how long was it going to go its own way? Less confusing was the fact that two other producers – Kuwait and the United Arab Emirates – joined the Saudis in the same quest: they have long concerted with Saudi Arabia in a common quest with respect to oil markets.

In retrospect, the apparently sudden turn in Saudi policy was the result of months of study of the rapidly changing global oil supply and demand conditions. The dramatic nature of the change reflects circumstances that have been developing since the beginning of this decade, with roots in the earlier years of this century. These conditions were apparently creating an existential threat to Saudi Arabia’s role in global energy markets.

Since the fall of 2013, Saudi Arabia’s state-owned oil company, Aramco, has run into persistent and growing problems in marketing crude oil, especially to its two largest customers, the United States and China. Saudi Arabia was exporting around 7.2-million barrels per day (m b/d) at that time, out of its average monthly production of some 9.5-m b/d. The US market received about 1.6-m b/d of Saudi crude, while China was receiving around 1.2-m b/d. But over time the exporter’s market share in its two largest markets fell disproportionately.

A supply story in the US...
In the case of the US, the loss of market share was initially gradual but built over time. Between late 2013 and mid-2014 Saudi export volumes fell from 1.6-m b/d to 1.0-m b/d mainly due to the shale revolution in the US, where domestic production rose by more than 1.0-m b/d for the third year in a row and obstacles to US exports were depressing the price of US crude versus the rest of the world’s crude oil. That meant that to maintain market share in the US, the Saudis would have to sell crude oil to the US at a lower price than it was selling oil into Europe or Asia. The Saudis increased export prices to the US and in effect intentionally lost market share. At its lowest point this past winter, Saudi exports to the US fell to just about 800-k b/d, a loss of half the country’s market share in little over a year.

Supply from the US was also starting to alarm the Saudis, as was new supply from two other new sources of “non-conventional” crude oil. The new frontiers of oil included shale (which enabled US production to grow by 90% since 2010), oil sands (where Canadian output increased by more than 40% over the same period) and deep water (where Brazilian supply grew by more than 25% and where US production, stalled after the BP Macondo disaster imposed a drilling moratorium, was starting to grow again). In 2014, supply from these unconventional sources amounted to about 1.8-m b/d, versus total oil demand growth of under 700-k b/d. Saudi Arabia was beginning to understand that its market position – and OPEC’s more generally – was being challenged by new unconventional oil output. In this sense the unconventional oil supply revolution has been the most politically disruptive situation in oil markets in decades and the largest challenge to Saudi Arabia and the rest of OPEC in their ability to impact the direction of prices changes as well as their level.

...but a demand story in China
Of greater concern was the loss of market share in China, where in the autumn of 2013 Saudi Arabia was selling 1.2-m b/d. This market was supposed to be the heart of global growth and the place where increasing share had been the core of Saudi export policy for years. The volume of Saudi sales in China also fell steadily from late 2013 to the summer of 2014, to an average of some 800-k b/d, dipping at times to 600-k b/d. Here, there was no competition from surging domestic oil production as was the case in the US, but rather the causes were startling drops in demand growth and competition from other suppliers – both factors that were harder to battle against.

On the demand side, the Saudis discovered that not only was Chinese oil demand growth falling along with the decline in Chinese GDP growth from over 10% annually to under 7% per annum, but the energy intensity and especially the oil intensity of China’s GDP growth were also falling. Most noteworthy was the sudden drop in China’s diesel demand growth. The core of China’s oil demand growth in the twenty years before 2010 was diesel fuel, which had been growing more or less in line with GDP growth. But then in 2011 it grew by 5% and stopped growing thereafter, even as GDP grew by around 7%. Last year diesel demand growth was actually negative. What happened was a sudden shift in the drivers of China’s oil demand growth, from high levels of fixed asset investment and urbanization away from urbanization to consumer-led growth. In early 2015, then Chairman Fu of Sinopec, China’s largest refining company, indicated that he expected China’s diesel demand to peak by 2017 and fall thereafter.

In addition to the core of China’s oil demand growth faltering and China’s market growing by a lower percentage each year, competition for the Chinese market also took a startling turn. China had already been changing the patterns of buying, favoring tying down supplies with “pre-export” finance through loans offered to foreign countries (among them Brazil, Ecuador, Sudan and Venezuela). But in the spring of 2014, when the European Union and the United States imposed financial sanctions on Russian companies and the Russian government cutting off access to long-term credit, China stepped in and offered long-term loans in exchange for long-term oil as repayment of the loans. This meant that the Chinese market was not only growing less rapidly but that competition for China’s market was intensifying, as long-term supply arrangements grew and in the face of growing new supply from Iraq due to new production and from Iran due to the expected end of sanctions in the near future.

Change in global demand growth driving overall Saudi strategy
It is now apparent that Saudi Arabia believes that oil demand growth is on a significantly lower path. The 2014 Annual Review published by Saudi Aramco in May 2015 indicated that between 2014 and 2040, a stretch of 26 years, oil demand was expected to grow by 18-m b/d, significantly less than 1%, falling to around 0.6% versus 1.5%-1.8% per annum growth previously assumed.

Thus both on the supply and the demand side, the Saudis concluded that they were confronting a long-term threat to their ability to manage markets and, more critically, to maintaining their market share, which is key to monetizing their extremely long position as the holder of huge oil and gas reserves. The shale revolution in the US, combined with growth in oil sands and deep-water output, were depriving them, and therefore OPEC as a whole, of the ability to target a price and to maintain it. The beleaguered outlook for global oil demand growth meant that if they stuck with their swing producer role and cut output last year, they were in danger of losing market share for a long time. As was the case in the 1980s when an oversupplied bear market was looming, if they cut output and lost market share, they would lose more revenue than if they strived for market share. One strong potential implication is that oil being produced in the short term is becoming more valuable than oil under the ground, an issue of significant market impact over the next few years.

Another factor in the Saudi change in strategy was the realization that the glut in the market was of light, low sulfur (sweet) crude oil and if OPEC did cut production, there would still be a glut of light crude (the kind produced by US shale oil E&P companies) and what’s worse it would continue to grow, subsidized by OPEC cuts and the lift a cut would give to global oil prices, further subsidizing US production growth.

A final factor on the oil side perhaps was the realization that it was exceedingly unlikely that other OPEC countries would join in an output cut. For all practical purposes Iraq had signaled it would not cut production and had a right to continue to grow its output given its having already in the past been under-producing and ceded market share to Saudi Arabia and other Gulf Cooperation Council (GCC) countries; Iran had a similar view, given it had lost export markets as a result of United Nations and Western-imposed sanctions; Libya was confronting fragmentation risk and was incapable of reducing production further. In general, the Saudis found themselves in an environment in which it was exceedingly unlikely that other OPEC countries would have been in a position to cut production and would be unwilling to share in the burden of adjustment requiring them to cut output either alone or disproportionately within the producer group. Moreover, the basic supply challenge was coming from the US, whose government would not be constitutionally capable of putting a lid on production.

Hence the Saudis came to the conclusion that they needed to announce a market share strategy that would result in much lower oil prices for a sustained period of time. In this lower oil price environment they would seek to shift the burden of adjustment to lower oil prices on higher cost producers, in particular the producers of unconventional oil whose production has taken most of oil’s market share during the current decade – shale oil in the US, deep water production globally and oil sands in Canada.

Despite the once prevailing view that the new strategy was designed to force a production agreement on OPEC countries and some critical non-OPEC countries such as Mexico and Russia, the Saudis appear to have both a longer view and a different set of targets in mind. The longer view is that oil prices will have to be lower for a long period of time, since shale production and deep-water production can grow even in a $75 price environment. The longer view also is that these new frontier sources of oil can rebound if and as global prices rise and, barring an increase in disruptions to supply, the Kingdom needs to secure market share and maintain it, leaving the burden of adjustment on other OPEC and non-OPEC countries.

As many commentators have noted, there has been an additional convenient consequence of lower oil prices for the Kingdom in that they have negative consequences for both Iran and Russia, both of which are pursuing goals in the Middle East that are against Saudi interests and for both of whom lower prices are massively painful. There are plenty of oil-market issues around which that impacted Saudi oil policy and that can explain the change in strategy without reference to these overlaying more political issues.

It’s hard to predict that any structural change in oil markets is “permanent” or “forever,” but it’s also difficult to understand how the oil market will be able to sustain higher prices or even a return to last year’s prices given the entry of shale oil, deep-water output and oil sands into the production system.

GPS Opinion
Natural Resources

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