How Saudis can cut oil production

Saudi Arabia is coming under increasing pressure to implement oil production cuts.

Last week Russia and Saudi Arabia announced a provisional plan to freeze oil production levels if other major producers went along. But by late in the week, with Iran balking as expected, both the Russians and Saudis were walking the deal back, with the Saudis categorically rejecting production cuts and the Russians averring that a 'freeze' actually allowed Russia to increase output.

Saudi Arabia's Oil Minister Ali al-Naimi.
Naseem Zeitoon | Reuters
Saudi Arabia's Oil Minister Ali al-Naimi.

To all appearances, the Saudis had not thought the matter through and were now sawing the branch off behind the Russians, who were in turn fleeing the scene. The freeze proposal had disintegrated into total chaos, with the Saudis clearly having blundered.

To repair fences—or at least provide clarification—Saudi Oil Minister Ali al-Naimi is scheduled to address attendees of IHS CERAWeek in Houston on Tuesday. The minister, who is considered the most influential policymaker in the industry, will face U.S. shale industry producers who have been devastated by the oil price plunge.

A production cut is considered a difficult, and perhaps insurmountable, challenge. In reality, the math is pretty simple, and Minister al-Naimi has only three questions to answer.

Will an OPEC cut restart U.S. shale production?

We calculate shale industry breakeven around $65 per barrel and do not believe we would see a material re-start to the industry under $50 per barrel on a WTI basis. WTI has recently been trading around $30 per barrel. Thus, OPEC could increase oil prices by $20 per barrel—60 percent—without risking a material revival of U.S. shale production.

Further, any OPEC and Russia production cut would automatically qualify as spare capacity to be called whenever prices rise again. Shale producers would have to take into consideration that OPEC and Russia would seek to preempt a rise in oil price above $50 per barrel by increasing their own production first. Thus, production cuts would not only increase prices now, they would also have a deterrent value later.

Is a production cut good for Saudi Arabia, and better for Saudi Arabia than it is for Iran?

A production cut is plainly good for all oil exporting countries, with a payback of 4-8 times the value of production cuts. But it is best for Saudi Arabia and Russia—as these are by far the two largest oil exporters. Consider the following scenario: Saudi Arabia and Russia cut exports by 500,000 barrels per day each, Iraq cuts by 200,000 barrels per day, and Iran increases exports by 250,000 barrels per day—a reasonably plausible deal.

Under such circumstances, the cutting countries would see an annual revenue increase of 55 percent, while Iranian export revenues would double. However, Saudi revenues would increase by four times as much as Iranian revenues, because Saudi Arabia would still be exporting so much more than Iran.

Is a 4:1 ratio attractive to Saudi Arabia? On plainly economic terms, it has to be. But of course negotiations at present are greatly complicated by regional conflicts. If Saudi Arabia needs a further concession—a political or security gesture—it should make the request in bilateral negotiations with the Iranians. Otherwise, Saudi behavior is counter-productive, not least to the interests of the Kingdom itself.

At a minimum, the Saudis are sacrificing $4 for every $1 of which they are depriving the Iranians. That's seems a poor deal on the face of it.

Can the deal be verified?

Any successful deal hinges on two factors: agreed production adjustments, on the one hand, and a verification scheme which insures compliance with agreed supply cuts, on the other. Compliance could be addressed in a number of ways. For example, the participants could report just as do International Energy Agency member countries like the U.S., Japan and Germany. This would involve disclosing oil production, stocks and exports monthly within two weeks of period close, with the IEA advising on reporting systems and monitoring compliance.

While intrusive for Russia and OPEC, such an innovation could prove of critical importance. In truth, we do not know the size of emerging economy (non-OECD) oil stocks or consumption with any accuracy. The IEA reports some 500 million "missing barrels" in the last five quarters. If these barrels are excess supply, then large production cuts are needed. If it turns out that the missing barrels were actually consumed by the emerging economies, then the required production cuts per country might be quite modest. If Russia and the Gulf states reported as do the OECD countries, then this uncertainty would be greatly reduced, and the ease of reaching a deal could be much greater. Indeed, oil prices could surge on data clarification alone.

Whatever Saudi Arabia does, it has to proceed with caution. Right now, Iran is making all the running. Tehran has successfully concluded a nuclear deal with the major powers and appears to be living up to its terms. The country has actively courted foreign investment, and leadership has even paid a visit to the Vatican.

Iran could have condemned the production freeze as deceptive and intended to deprive Iran of legitimate production gains—both of these were true. Instead, Iran endorsed the deal but respectfully demurred from participating, leaving the Saudis looking like bunglers two days later when they categorically rejected plainly necessary and beneficial production cuts.

The world has changed. Iran is back on the scene. Saudi Arabia now has to play a more sophisticated and nimble game. Just saying 'no' won't be enough anymore.

Commentary by Steven Kopits, president and managing director of Princeton Energy Advisors, an oil and gas consulting firm that advises hedge funds and oil equities investors. He previously ran the New York office of Douglas Westwood, energy industry consultants, and earlier worked as an investment banker with Dahlman Rose & Co.

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