Has Saudi Arabia accepted its oil policy was faulty?

Saudi Arabia leading the oil cartel, Organization of the Petroleum Exporting Countries (OPEC) has surprised oil traders and analysts by announcing a production deal at the end of a recent but informal meeting in Algiers. This is after a long time that Saudi Arabia has consented to production cut. In 2014, against all odds Saudi Arabia had decided to enhance output for retaining its market share.

At Algiers, OPEC members committed themselves to an overall output level. The cartel issued a statement comprising of less than 700 words, out of these the two most important announcements were: 1) commitment by 14-member cartel to fix a maximum ceiling of 33 million barrels daily out (bpd) and 2) announcement to establish a committee to study the implementation of fixing new production levels for individual member countries and to consult with non-OPEC oil producing countries.

The critical question remains whether the production target will affect the actual number of barrels being marketed by the organization's members?

In response to the OPEC decision, oil prices settled mixed on Friday while posting their second straight monthly gain. While skepticism prevailed about the cartel's pledge, some analysts believed that the global oversupply at the maximum is around 1.5 million bpd. This can be managed easily if every member acts prudently. Saudi Arabia has the highest responsibility to set precedence by cutting its output up to 750,000 bdp and also to reap the highest benefits. Some analysts believe that Saudis probably calculated that an increase in prices to $50-60 per barrel would bring useful extra revenue to them without stimulating too much production from other sources due to some prevailing constraints.

If one looks at OPEC's latest production figure, it prompts even bigger cut. They are all Petro states suffering from low oil prices. It is prudent for them to cut production a little voluntarily and get a meaningful increase in their revenue. The mere announcement about production cut has raised oil price by more than 5 percent and actual cut could bring even higher gains.

Russia, one of the arch rival of Saudi Arabia in geopolitical arena, has been producing/pumping crude at record highs, said it would find a way to freeze production if a deal is reached with OPEC. The US ‑ present foe but a friend of yester years, also a non-OPEC member and now the biggest oil producer ‑ said on Thursday it had little faith in the OPEC plan. U.S. energy envoy Amos Hochstein told Reuters that any price gains from the cuts would trigger higher U.S. production, which would ultimately defeat the deal. This is a real treat as a weekly report about U.S. oil rig count showed local drillers have added 95 rigs for the third quarter, the most in any quarter since 2014.

Within OPEC and besides Saudi Arabia, supply has risen since 2014 as OPEC relinquished its historic role of fixing output to prop up prices as Saudi Arabia, Iraq and Iran wanted to pump more oil.  Supply from Iran, another arch rival of Saudi Arabia has posted the fastest increase in exports after the lifting of Western sanctions. Its production is inching towards the pre-sanctions levels.

The kingdom’s change of heart seems to have come from a realization that low oil prices were not rebalancing the market in the way that official hoped. Lower prices were expected to curb production by other producers with higher costs while improving the kingdom’s long-term position. Shale production in the US has been falling since early 2015 but it has been more than offset by increasing output from OPEC members.

The kingdom’s strategy assumed that it had sufficient financial resources to withstand a prolonged period of low prices while competitors would be forced to scale back. But the downturn in oil prices has lasted much longer than and shows no sign of ending. Falling oil revenues have pushed the kingdom’s economy close to or into recession and forcing deep cuts in government spending on infrastructure as well as social payments and salaries. Saudi Arabia’s foreign reserves have declined by $182 billion, a fall of nearly 25 percent, since August 2014

The decision certainly shows a strategic shift at the top of the Saudi administration, where Deputy Crown Prince Mohammed bin Salman has emerged as the key decision-maker. Prince Mohammed indicated earlier this year, it would not matter for the kingdom whether oil prices were $30 or $70 per barrel. But in recent months officials have realized that prices are unsustainably low and want them to rise.

Moral of the story is that Saudi policymakers are making another big assumption that rival producers have little capacity to raise output in the short term. They may be partly right because Iran is close to its pre-sanctions production capacity and will need significant investment to achieve substantial increases in output. Russia too probably has limited ability to increase production in the short term.

However, the key threat that remains is a potential increase in shale production in the meantime. U.S. shale companies have already added more than 100 drilling rigs since the end of May, despite the fact that the sector remains under intense financial pressure.