In advance of OPEC’s November 30 meeting in Vienna, at which they will seek to reach agreement on a production cut to between 32.5 and 33 mbd, it is worth reflecting on historic dynamics in the cartel. The likely outcome is a lack of agreement and a continued supply surplus that will weigh on oil price and structure.
OPEC represents a complex version of the classic game theory problem, the prisoner’s dilemma. To optimise collective value creation, OPEC members should increase production when prices are high, to gain market share, and reduce production when prices are low, to support price recovery. Research demonstrates, consistent with other prisoner’s dilemma problems, each OPEC member is instead individually incentivised to increase production whether prices are low or high. This has been the behaviour exhibited by most OPEC members throughout the cartel’s history.
OPEC has previously found alignment during periods of recession, with sharp demand contraction leading to price declines, bouncing back as the economy recovers and removing the need for sustained OPEC cohesion. Current price weakness is driven instead by excess supply and anaemic demand growth, leading to a flatter supply cost curve. The price response from reduced OPEC supply is therefore muted, making cuts financially painful for those who participate as they sell less volume without enjoying a sufficiently higher price. This dynamic is compounded by faster supply response times from US shale producers, who will seek to expand market share again if prices rise. When combined with extraordinary capital market liquidity, keeping access to finance open and debt affordable, the current dynamics are likely to persist for an extended period unless there is material cohesive OPEC action or major disruption in a key producing country.
Looking at who might align on production cuts, Libya and Nigeria are dealing with domestic conflict that has already impacted production, a dynamic that is mitigating at the time of writing, bringing more volume to market. Venezuela and PDVSA can ill afford to contribute, although desperately need higher prices to improve their precarious fiscal situation before they contribute involuntarily through a collapse of their government, their oil industry or both. Algeria, Angola, Gabon, Ecuador and Qatar are relatively stable yet declining producers that have not contributed meaningfully to OPEC actions previously and are unlikely to this time. Iraq’s government is embattled in conflict with ISIS, has fiscal troubles already requiring formal IMF Stand-by Arrangements and their diversified producer base operates under service contracts with volume targets to achieve anticipated financial compensation, making it hard to constrain production. This confluence has seen Iraqi exports grow strongly over the last few years, a dynamic that is expected to persist.
Having faced difficult economic restructuring decisions while under sanctions, Iran is under little pressure to support a price increase and with exports approaching or even at pre-sanction levels it is now more a matter of relative market share with Saudi Arabia. This issue of market share is one that Iran will be reluctant to cede lightly to their ideological rival, although some indication has been made that Iran will consider pausing at or near current levels of production, which may represent a compromise driven in part by the need to secure and implement investments to grow further.
This leaves the traditional “core OPEC” countries of Saudi, UAE and Kuwait. In the past the easiest way to characterise OPEC was that they all cheat, excepting this triumvirate, with UAE and Kuwait only contributing when absolutely necessary. The challenge for Saudi is UAE and Kuwait may not believe a cut is absolutely necessary given their strong financial positions. Kuwait will also rightly feel they have made a material contribution already through Saudi’s shuttering of the shared Neutral Zone production in 2015.
The non-OPEC producer that may come to Saudi’s aid is Russia. Whether inclined to help or not, Russia’s oil market is largely built from myriad public and private interests rather than the centralized command and control structure of Saudi Aramco, the “K Companies” of Kuwait, ADNOC in Abu Dhabi or NIOC in Iran, all of whom have a true ability to regulate their production and exports. Roseneft is unlikely to burden a cut unilaterally, leaving a Russian freeze the best case scenario that Saudi can hope for.
Russia’s blunt control instrument is allocations on the Transneft pipeline system. In previous promises to restrain supply, Russia has generally seen production and exports increase as their private sector takes advantage of higher prices, working their way around the Transneft control point, even when Russia has invoked it. With cash reserves declining $40 Billion in 2015 to stand at just $45.5 Billion in January 2016, Russia is more likely to contribute to supply curtailment by increasing taxation on the industry, a likely outcome irrespective of OPEC’s deliberations, however this lever takes time.
Rather than an aligned and multi-lateral agreement to reduce production at OPEC’s November 30 meeting it is more likely to be outright disagreement, or a hollow agreement that once again leaves the burden to cut on Saudi Arabia, with potential support from the UAE.
The probable result of this lack of accord is that a production cut is not achievable, with oil prices unlikely to sustainably hold above 50 $/bbl in the short term without significant support from external factors.