What are the prospects for a rumoured Opec oil production cut? Would it make sense?
At a time of oversupply, the key may be which producers have the lowest cost of decreasing production. As a practical matter, Opec is best positioned to enact a supply cut.
In the two years to April 2015, the US oil supply increased by a whopping 3.1 million barrels per day – enough by itself to more than cover global demand growth for that period. In the past year, however, US production has fallen by 400,000 bpd. The United States is no longer driving the global supply glut.
On the other hand, once a base of shale production is brought on line, maintaining it can be achieved with much lower investment and vastly fewer rigs. US oil production has fallen only 100,00 bpd in the past six months, despite oil rigs off by two-thirds from the cycle peak. If shale production is not going up, it is not coming down much either.
In aggregate, the US Energy Information Administration predicts that US onshore production will decline by 400,000 bpd this year, far too little to balance markets. True, some analysts expect a bigger drop, as much as 1.1 million bpd this year.
But even that might not be enough. The EIA estimates that supply currently exceeds demand by 1.5 million bpd. If demand growth is modest and other supply comes on line, then US production declines may prove insufficient.
But if US production is falling, where is the imbalance originating? Who is adding all that supply? The culprit, it turns out, is Opec itself. Since November 2014, Opec crude and refined product exports are up about 1 million bpd, split about equally between Saudi Arabia and Iraq. Moreover, growth is forecast to continue.
The EIA predicts that Opec production will rise 1.6 million bpd over the next two years, of which half is anticipated to come from Iran. Thus, since early last year, US shales have not been the cause of depressed oil prices. Opec is. By implication, Opec should act to restore market balance.
If the supply surplus were eliminated or materially reduced, oil prices could rebound quite quickly, conceivably returning to the US$50 per barrel range. At this price, US shale operators would still lack much incentive to ramp up production, allowing Opec to both enjoy much higher oil prices and keep shale on the sidelines.
But it has to be a joint effort. The surplus is too large for Saudi Arabia to tackle alone. A reduction today also requires contributions from Iraq and Iran. Together they can stabilise the market. For example, Saudi Arabia could cut production by 500,000 bpd; the Iraqis could reduce by 250,000 bpd; and the Iranians could agree to limit production gains to 250,000 bpd this year. This would be likely to increase oil prices by $10 to $20 per barrel, representing a four-fold to eight-fold gain on foregone production.
The call for Iraq to cut supply is novel. Iraq has generally been treated as exempt from production cuts as it seeks to regain earlier production levels and approach the scale of Saudi Arabia as an exporter. This is all fine and good, but Iraqi exports have increased by 600,000 bpd over 2014 levels. The Joint Organisations Data Initiative reports that Iraqi November exports were up nearly 900,000 bpd over the same month a year earlier. This kind of export surge crushes oil prices. Iraq has to acknowledge that it is materially contributing to price weakness and bears shared responsibility to balance markets.
In comparison, Iranian oil exports are modest. However, as a result of the nuclear deal agreed with the major powers, Iranian production is slated to rise dramatically over the next two years. No cut from Iran should be reasonably expected. However, moderated supply growth is essential, as uncertainty about Iran’s production potential is also depressing oil prices. Will the country increase output by only 250,000 bpd, as some analysts think? Or can it reach for the entire 1 million bpd that Tehran itself has mooted? A smaller increment released with greater certainty would do much to shore up prices. Limiting Iran’s production growth below 250,000 bpd this year would be very helpful.
Can a deal be achieved? Given the frictions between Saudi Arabia and Iran, bringing negotiators to the table could prove daunting. But it would make sense, even for Saudi Arabia. Because the kingdom is such a large oil exporter, and large compared to either Iraq or Iran, any oil price recovery would help Saudi Arabia far more in absolute terms.
For example, the deal presented above would increase Iran’s income by $12 billion but Saudi Arabia’s by $60bn.
Such an agreement would also create a platform for the Saudis, Iraqis and Iranians to discuss shared interests. Although the conservative US press has decried any normalisation of relations with Iran, for the first time in 35 years the Iranians and the Americans have been able to make progress, however imperfect. Of course, Iran’s opening to the international community may prove abortive. But the country has shown at least limited willingness to interact with the US. Perhaps this provides an opening for a broader dialogue, including an opportunity for regional discussion and cooperation on oil market initiatives.
This may matter even more given the uncertainty in China. Will the Chinese economy hit the wall? If it does, the production cuts required to balance the market would far exceed Saudi Arabia’s individual capacity. The establishment of a coordinated decision-making system among the Saudis, Iraqis and Iranians could prove invaluable in such an event.
US shales may have tanked oil prices through last spring, but recent and prospective oversupply stems from three countries – Saudi Arabia, Iraq and Iran. If these countries want their oil revenue to go up, they need to sit down at a table and work out a deal.
Steven Kopits is the president of Princeton Energy Advisors in New Jersey.
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