An official of Saudi oil company Aramco watches progress at a rig at the al-Howta oil field near Howta, Saudi Arabia.JOHN MOORE/The Associated Press
Oil prices reached almost $50 (U.S.) a barrel on Tuesday, a gain of more than 10 per cent in the past week, as oil traders bought into the theory that the OPEC free-for-all is about to end. But if OPEC heavyweight Saudi Arabia succeeds in pushing up prices, and they stick at $50-plus levels, will it be a winner or a loser?
The Saudis thought they were clever two years ago, when they abandoned their traditional oil strategy. Instead of trimming their own production and persuading the other 13 Organization of Petroleum Exporting Countries members to do the same to prop up prices in the face of surging output from non-OPEC sources, notably U.S. shale oil and the Canadian oil sands, they did the opposite.
The Saudis, weary of losing market share, gambled they would win a price war. Classic economics kicked in and prices duly slumped, then plummeted, hitting $30 early this year before recovering somewhat.
The gambit didn't really work. While U.S. production fell about 500,000 barrels a day, the shale industry impolitely stayed in business, as did the oil sands. The low price saw Saudi Arabia burn through about $250-billion in foreign-exchange reserves and its market share didn't really improve; it actually lost share in the big-gulp countries – India, China and the United States.
Realizing their costly mistake – Saudi Arabia needs about $80 oil to clear its budget – the Saudis are now lobbying for formal agreement on a production cut at next week's OPEC meeting in Vienna. It won't be easy, since some OPEC members argue they should be exempt. Iraq, which is fighting the Islamic State within its borders, has made it clear it would rather increase production than trim it. Ditto Nigeria and Libya, whose oil installations have been severely damaged by terrorist attacks. They're in rebuilding mode.
Still, the betting in the market is the production cut is coming. The price surge says as much. In a Tuesday note, Helima Croft, head of commodities strategy at RBC Capital Markets, said "we remain of the view that OPEC will stick the landing on November 30. Our view is primarily based on the belief that the single most important country in OPEC, Saudi Arabia, wants it, and that the ability of a number of suspected cheaters to cheat is constrained."
Citigroup's energy team also thinks a production cut is more likely to happen than not. It's calling for a fall of about one million barrels a day.
Now, suppose the production cut works and prices rise above $50, perhaps hitting $60 or even $70. Wouldn't that be a Pyrrhic victory for the Saudis?
The U.S. shale oil producers would surely ramp up production, all the more so since vicious price-cutting since 2014 saw their costs fall by an astounding 40 per cent, dropping their break-even price and raising their margins. Higher oil prices would also trigger new development projects from Canada and Russia to offshore Brazil and West Africa. In other words, the Saudis' market share – OPEC pumps one in three barrels produced globally – would keep falling as non-OPEC supplies reacted to the high-price signal.
Surely that vision haunts the Saudis. But maybe they have found a way to have it both ways.
As RBC noted in a report published two weeks ago, oil companies do not base their big capital investments on the spot price – the immediate price. If the spot price today were $50 but the longer-term future price were, say, $75 – a contango – the development department might be tempted to green-light the project. In the reverse scenario, where the spot price was $75 and the future price was $50, the project probably wouldn't see the light of day.
So the trick, according to RBC, is for the Saudis to allow the short-term price to rise and keep the longer-term price low, all the better to ensure that big oil projects remain stuck on the drawing board. But how? RBC thinks Saudi Arabia, ever so quietly, could use a hedging program that would use over-the-counter derivatives to sell the forward oil contracts, putting downward pressure on prices. "Methodically selling or layering in hedges every month or quarter would keep perpetual pressure on the term portion of the forward curve," RBC says.
It's an intriguing idea the Saudis have no doubt considered, although there is no guarantee they will unleash the strategy or that it would work if they do. But you have to think that Saudi Arabia, having put the oil-producing world on notice that it will defend its market share, will stop doing so forever.