Saudi Arabia “Catch 22”: OPEC cut extension or oil slump 2.0?

International oil markets are heading towards increased volatility if OPEC members are put under severe stress. Current oil price developments, showing high volatility but still below expected price levels, show that an expected oil market rebalancing is still weak. Some even expect that the future rebalancing has been delayed by several months, due to a continuing increase of shale oil production in the US and some non-compliance issues within and outside of OPEC.  At present, Saudi Arabia, which was declared dead some months ago by mainstream analysts, is taking the brunt of oil export cuts. GCC Arab producers are complying also to expected levels, but some discrepancies are clear, Iran and Iraq are confronting Saudi oil policies still.

When taking into account the ongoing focus on oil storage worldwide, which still is not showing a real decline — especially in the US — some doubt that oil prices will recover fully in 2017. Still, there is a lot of green on the OPEC tree, as prices are recovering, but it is still a fragile situation. Contango in the market for Brent delivery June or December 2017 has not moved really, sitting at $0.82 per barrel. Some weakness is shown in the June spread, but December has however strengthened. When looking at hedge funds, the picture is clear, most expect a tightening in the market. A move into backwardation is expected Q3-Q4 2017.

The main threat, as reported in the media, is that crude inventories in the US are still building up. Even that latest reports, by upcoming analyst group Tanker Trackers, are showing that real increases are very low, but still the picture is unclear. Some analysts also have stated that recorded inventories are increasing due to storage of before not-reported stockpiles.

When looking at the bigger picture, more and more reports indicate that OPEC storage volumes are very low. Iran almost needs to report empty storage figures at sea. Saudi Arabia is also reported to have almost drained its producer stocks. This OPEC movement is also shown in OECD reports, as it means that producers (OPEC) are moving their stocks closer to refineries at present, which are mainly situated in Asia or OECD countries. This could partly explain the continuing inventory increase and reduced producer stocks lately.

When looking at Saudi Arabia, the picture is also unclear. Riyadh still is officially committed to the agreed upon production levels of OPEC and non-OPEC. The Kingdom also has openly requested other OPEC and non-OPEC members to roll-over the production cut agreement for another six months. Pressure has been put not only on Arab producers or Russia, but also surprisingly on the US shale oil producers. The Saudi pressure is significant as until now the market acknowledged that to constrain shale oil production would be very hard to put in place. To call on US producers to take part should however not be seen as a sign of weakness. Riyadh’s underlying message is clear to some. If non-OPEC producers will not increase their share of production cuts soon, the OPEC leader could decide to open up another road to support its own (market-share) interests. A renewed oil price war could happen, now being started by Aramco at a time that its future is being decided. A possible price war, leading to a price plunge worldwide, would definitely hit Aramco’s IPO and Saudi Arabia’s economic reforms very hard.

The latter has already been put into action. Saudi Arabia has lowered prices for crude and petroleum products to Europe. The latter is seen as a direct attack on the growing market shares of Iraq and Iran, while openly countering Russia’s dominance in the market. Surprisingly, Europe has been showing demand growth the last two years.

Still, main concern for Saudi Arabia should be the ongoing volatility in the market. Unless oil prices are not going to hit $60 per barrel soon, the Aramco IPO will be feeling the heat. With an IPO deadline set for 2018, the market needs to become confident that taking part in the IPO will be feasible and commercially interesting. As former Saudi ministry of petroleum advisor Ibrahim al Muhanna already stated the last days, to balance the market really a price of $70-80 per barrel is needed. The latter will increase the options of operators to invest again heavily in oil and gas. The last couple of years more than $700 billion investments were deferred or put on ice, currently already hitting the oil sector in full. With no real new investments oil (and gas) production will be constrained, as decline of production and no new discoveries will be detrimental to production levels from 2019-2022 onwards.  With a demand growth expected the coming years, hitting 108 million bpd in the next years, a lot of new discoveries or expansions need to be done. Saudi’s role in the latter will be pivotal, as it is one of the only producers holding enough proven reserves to supply additional volumes. The latter will however be under threat if price levels stay low, and investment decisions are being deferred.

As indicated by most analysts, Saudi Arabia is shouldering most of the production cuts. When looking at total OPEC, compliance figures are promising but disputable. Analysts don’t agree with the figures available, especially when taking out Saudi Arabia’s cut. Some show a compliance of 70% while others are almost overjoyed and report 100%.  The market is also looking at OPEC members, which are not bound by the cut agreement, such as Libya, Iran and Nigeria. These producers partly have offset the OPEC production decline. Still, room for optimism is there. As most of the market is looking at Saudi Arabia, Russia and the US, Iran’s optimistic statements are currently overlooked and misinterpreted. Facts on the ground show that Iran has been heavily drawing from its floating inventories, currently estimated to be almost empty. At the same time, analysts from Tanker Trackers have indicated that Iran has been only exporting around 1.3 million bpd in the first days of April. This could be a sign that a reassessment of the market is needed. If Iran, and others are not physically able to keep or increase production at former levels, a further drawdown of global inventories is to be expected. Also the US shale production increase, which is estimated to be around 600K bpd in 2017, will not constrain a rebalancing of the market. The indicated extension of the OPEC – non-OPEC production cut agreement could result in a faster recovery of oil prices than currently is being indicated.

For the coming months, a price rally can be expected, if OPEC and non-OPEC will keep to the current agreements. Taking out the geopolitical risks factors, global demand will most probably not even be met without a direct draw on inventories.  If risk premiums will increase, due to Syria, Iran, North Korea or even Libya, an upward potential of $10-15 per barrel exists. Without increased geopolitical risks, but looking at the struggling Iranian-Libyan and Nigerian production figures, prices could be hitting $60-65 at the end of 2017.

The above picture bodes well for Saudi government revenues and economic growth potential. With increased revenues the current draw on foreign reserves will be countered. However, Aramco and Riyadh will need to play the game very carefully not to disturb the market and get a counter reaction from customers. Overall, higher oil prices also will support the ongoing economic diversification drive (Saudi Vision 2030) as financial resources will be there to continue with the investment projects. 

Cyril Widdershoven is a geopolitical and oil & gas analyst covering the Middle East and North Africa region, as well as Turkey. He is the founder and director of Verocy, a Netherlands-based consultancy.