Chinese strife and US ‘fracklog’ put Opec’s cheap-oil strategy into question

The question of Opec action to address the oil glut has been mooted for nearly a year, as the group’s Saudi-led policy to allow lower prices to squeeze out higher-cost production seemed pretty well set in stone.

But that question is back on the agenda after the late-summer meltdown in China’s financial markets, which has raised the prospect of slower oil demand growth and an even longer period of financial pain for oil-dependent countries.

The question, however, remains as vexing as ever: can the producer group agree to some type of short-term fix that could stabilise prices at a higher level without risking the longer-term aim of forcing out higher-cost producers?

Some analysts think the combination of the deal to ease sanctions on Iran and the growing problems in China’s economy will provide enough cover for Saudi Arabia to reverse its policy and find a way to cut output without losing face.

“The root of the problem is that the people running Saudi Arabia represent an older generation that have not realised that the oil market has changed dramatically and that they cannot control it as they did in previous decades,” said Nick Butler of King’s College London, a former head of strategy at BP. “They wanted to force other people out of the market and didn’t realise shale producers in the US have managed to cut costs and keep going,” he said in a recent BBC discussion.

The latest data showed that US oil production has slowed down since last year’s oil price slump.

Last week, the US government’s Energy Information Administration said June oil production was about 9.3 million barrels per day (bpd), down 100,000 bpd from May and 250,000 bpd below the agency’s previous estimate after figures were revised using its new survey-based method.

The sharp decline in the rate of rigs in use in US oilfields does seem to have had the effect of curbing supply growth.

But the quandary for Saudi Arabia and Opec is that it has become increasingly apparent that, while lower prices might have forced a cut in US production, that can be quickly reversed.

“The problem is that if the oil price does start to go up, you have the so-called fracklog,” said Paul Stevens, an analyst at Chatham House. As he explained it, the fracklog refers to a technique US drillers use now in which they partially drill a large number of wells and leave them idle while prices are low. They can bring the wells back very quickly when prices rise again.

“Some [Saudi policymakers] are realising now that they can’t play the market as they hoped to,” Mr Butler said. “I suspect they will go back to something like the old model and try to organise a cut in production over the next few months.”

Mr Stevens agrees that US oil industry flexibility, coupled with the prospect of additional Iranian supply, has given Saudi Arabia the cover to discuss a curb in Opec output in the run-in to the next scheduled ministerial meeting in early December – or even before that if oil markets weaken sharply in the interim.

Saudi Arabia’s policymakers may now realise that they cannot just rely on a policy of aggressive market share defence and expect the high-cost producers to balance the market eventually. The Chinese financial meltdown has shown that other factors can unexpectedly extend the period of oil-price pain for oil-dependent economies and put them under too much strain.

An irony of the Opec policy is that the pressure it puts on its weaker members is likely to lead to a ratcheting up of internal tensions and political strife, thus increasing risks and lifting oil prices.

As Richard Cochrane of IHS points out, the fighting in Libya over the past year “has undermined oil production, creating a financial crisis and probably rendering the country bankrupt by 2017”.

Internal strife is also increasing in Algeria as its economy struggles to deal with lower oil prices. The country’s energy minister, Salah Khebri, last month reportedly wrote to Opec urging a change in strategy. The country requires oil prices close to US$121 a barrel for its budget to break even.

World benchmark North Sea Brent prices have averaged just over $57 a barrel this year, and fell to an average of $48 last month as the China crisis took hold.

The biggest battle within Opec, however, will be between Saudi Arabia and Iran. The latter’s oil minister, Bijan Zanganeh, has repeatedly warned this year that Iran plans to recapture its lost market share as soon as sanctions are lifted.

Iran’s ability to ramp up production is a highly variable factor. As a new analysis by the AT Kearney consultancy notes, the estimates of Iran’s ability to raise production over the next 18 months to two years vary from 300,000 bpd to 800,000 bpd.

But as Saudi Arabia and Iran dominate the potential spare capacity within Opec, that may give them scope to strike a deal to share the bulk of the burden of output cuts.

Even just the appearance of a deal to restrain output might be enough to get oil prices on to a higher plateau next year. As Tom James, an analyst at Navitas Resources, pointed out, China continues to hit new record-high levels of crude oil buying, despite the problems in its currency and equity markets.

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Anthony McAuley

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