The Sad Truth About The OPEC+ Production Cut

By Simon Watkins

Quite aside from the subtler elements of the oil deal announced late last week that are likely to undermine its ability to stave off further oil price lows in the coming weeks, the basic facts of the deal are sufficient to do so: global supply is to be cut by (sort of) 10 million barrels per day (bpd) whilst global demand has fallen by around 30 million bpd. That is really all anyone needs to know and is the key reason why oil prices are likely to continue to test the downside of recent lows and to surpass them over time. Terrible though these raw figures look, the overall deal itself is much worse the more that it is examined in depth, as it is below.

Before the Saudis decided to again gallop gaily into the ranks of the intellectually dispossessed earlier this year by trying exactly the same oil pricing strategy (i.e. bankrupt other producers by overproducing and crashing oil prices) that failed so abysmally from 2014 to 2016, the global oil market was at a fairly balanced point. Oil demand was around 100 million barrels per day (bpd) with the Brent oil price set in the US$50-70 per barrel range, albeit with a bias towards the lower end of that scale. The best U.S. shale producers were able to make decent money above the US$40 per barrel level, as was Russia, which has a budget breakeven price per barrel of Brent of precisely US$40. Only Saudi Arabia was in trouble, with a budget breakeven price of US$84 per barrel of Brent but that was its own fault, a product of the legacy of the aforementioned disastrous price war on shale from 2014 to 2016 and of the various vanity projects and vanity war in Yemen of Crown Prince Mohammed bin Salman (MbS).

Saudi Arabia was continually peeved not just by the fact that it had to pay the price for underestimating the tenacious adaptability of the U.S. shale industry back in 2014 that allowed these producers to reduce breakeven prices from around US$70 per barrel to less than US$40 but also that its efforts to keep oil prices up through various OPEC and OPEC+ agreements were allowing these very shale producers to make a lot more money than the Saudis, relatively speaking. The reason for this was that U.S. shale producers – over 90 per cent of which are still relatively small, independent operators – were not bound in to the OPEC/OPEC+ production quotas so could fill the output gaps created by OPEC producers (Russia, as the significant ‘+’ in ‘OPEC+’, never took any notice of its quotas).

This allowed the U.S. a rolling 3-4 million bpd advantage over Saudi in the oil exports game, meaning that it quickly became the world’s number one oil producer, while Russia (which, remember, ignores all quotas) became number two, and Saudi Arabia (which broadly abides by most of the quotas) trailed at number three. Hence, Saudi Arabia decided initially to unilaterally announce its intention for the last OPEC+ deal to be much bigger than that which it had pre-agreed with Russia, hoping to ambush the Russians into agreeing. Russia, however, turned around and told Saudi Arabia to figuratively go and reproduce with itself. MbS, who has surrounded himself with ‘yes men’ within his government and foreign advisers who are worried about losing his business, then decided to launch an all-out price war.

The reason why this has been such a short-lived war is that – for the reasons outlined above – nobody wanted to tell MbS that he had forgotten to factor in a key element, and that was the deal made in 1945 between the U.S. President Franklin D. Roosevelt and the Saudi King at the time, Abdulaziz, that has defined the relationship between the two countries ever since. As analyzed in depth in my new book on the global oil markets, the deal that was struck between the two men on board the U.S. Navy cruiser Quincy in the Great Bitter Lake segment of the Suez Canal was that the U.S. would receive all of the oil supplies it needed for as long as Saudi Arabia had oil in place, in return for which the U.S. would guarantee the security of the ruling House of Saud. The deal has altered slightly ever since the rise of the U.S. shale oil industry and Saudi Arabia’s attempt to destroy it from 2014 to 2016, in that the U.S. still guarantees the security of the House of Saud but it also expects Saudi Arabia not only to supply the U.S. with whatever oil it needs for as long as it can but also – and this is key to everything that has followed – it also allows the U.S. shale industry to continue to function and to grow.

As far as the U.S. is concerned, if this means that the Saudis lose out to U.S. shale producers by keeping oil prices up but losing out on export opportunities to these U.S. firms then tough: it is money well spent by the House of Saud for the protection of the U.S. As U.S. President Donald Trump has made clear whenever he has sensed a lack of understanding on the part of Saudi Arabia for the huge benefit that the U.S. is doing the ruling family: “He [Saudi King Salman] would not last in power for two weeks without the backing of the U.S. military.”

Aside from fundamental mathematical failure of the oil deal, then, what else is wrong with it? For a start, there is the usual nonsense of the ‘baseline levels’ from which production is judged to have been cut. Both Saudi Arabia and Russia are to ‘cut’ around 2.5 million bpd each but only from the production baseline level of about 11 million, according to the OPEC statement last week. However, Saudi has never recorded sustained actual oil production of more than 10.5 million bpd for more than a brief period. The recent often-quoted ‘supply highs’ of over 12 million bpd are not – repeat not – actual production but rather production plus the use of oil inventory.  To put it into historical – and real – terms, the average Saudi production from 1973 to the beginning of this year was 8.15 million barrels per day. This means that the Saudis are not in reality cutting production at all, it is just going to cut back on the use of its oil inventory, which it cannot afford to keep squandering at such low prices anyway. Russia, in the meantime, is geared up to produce around 11 million bpd anyhow – the baseline figure – so again this effectively means no cut, and even if the baseline figure was lower, Russia would take no notice and produce whatever it wanted, as it has done for every OPEC+ deal with which it has been involved, since the first agreed cut in December 2016.

The third key failure of this deal is that the prospect of failure is explicitly built into it, in the form of a sliding scale of production reductions that are to be reviewed on a rolling basis as the market moves forward. Specifically, OPEC+’s tentative plan would see the output curbs dramatically reduced after two months, depending on the evolution of the coronavirus, with the 10 million-barrel-a-day cut liable to be reduced to 8 million a day from July and then to 6 million a day from January 2021 to April 2022, according to the OPEC statement. The group is planning another videoconference 10 June to discuss what additional measures need to be taken, which means that any slim optimism that may have supported oil prices has immediately been undermined with the prospect of a complete change to the parameters of the deal so quickly. With this prospect of reducing production quotas so close, it is also not unreasonable to expect the OPEC and OPEC+ producers to take a less than stringent approach to the absolute level of their oil production or exports, of course, although in the case of Saudi Arabia and Russia, the quotas, as mentioned, are meaningless.

By Simon Watkins for