COLUMN-For OPEC, the first cut is likely to be the easiest: Kemp

Tue Jul 16, 2013 3:45pm BST

(John Kemp is a Reuters market analyst. The views expressed are his own)

By John Kemp

LONDON, July 16 (Reuters) - Sooner or later OPEC members will have to reduce output to reflect their reduced share of the global oil market.

The organisation's members must come to terms with diminished demand for their crude as a result of booming shale oil production in North America and strong production growth in several other regions.

The only real questions are how much of the burden of cutting production will fall on Saudi Arabia and whether they will be implemented through the framework of OPEC or unilaterally.

SAUDI FIRST CUT

The first cut, whenever it comes, should be fairly easy. It will probably fall almost entirely on Saudi Arabia and its close allies Kuwait and the United Arab Emirates. Contributions from other OPEC members are likely to be fairly token.

The first cut would merely go some way to reverse Saudi Arabia's increase in market share at the expense of other OPEC members in recent years.

Saudi Arabia's share of OPEC exports has risen sharply as the kingdom has replaced a drop in Iran's oil shipments resulting from sanctions. Output has also fallen in Nigeria and Libya because of production problems, security concerns and increasing competition from North American shale producers.

Other OPEC members will expect Saudi Arabia and its close allies to make all or most of the first round of cutbacks. The kingdom should be able to absorb them without too much impact on its budget.

For this reason, it makes little difference whether the first round of cuts is implemented unilaterally, through quiet adjustments to Saudi Arabia's export volumes, or via an OPEC accord.

The problem is that the first set of cuts is unlikely to be the last. Future rounds will be much harder to agree upon as members differ over how to share them out.

Competition from shale oil threatens to revive all the old divisions over how to divide output among the organisation's members amid declining market share for OPEC as a whole.

OLD DIVISIONS

The Organization of the Petroleum Exporting Countries has never managed to function as a very effective cartel in the formal sense of a group that shares out production capacity or production.

Member countries have normally found it easier to agree on a target price than on how to divide production up among themselves. The organisation did not even set production allocations until 1982.

In recent years, OPEC has given up trying to set allocations altogether, instead announcing an overall production target but no distribution among members, and even this has largely been ignored.

OPEC has been rescued from the internal squabbles about quotas and cheating by strong growth in demand for its oil, and a series of wars, sanctions and production problems that have led to output declines from Iraq, Iran, Nigeria, Libya, Algeria and Venezuela at various times over the past decade.

The past 10 years have been a golden age for those OPEC members that could increase output - basically Saudi Arabia and its close allies plus latterly Iraq but not Iran and most of the African and Latin American members.

That golden age is now drawing to an end. OPEC's stronger producers must now confront the reality of sustained declines in demand for their output for the first time in a decade.

PRICE PREDICAMENT

Oil prices are well above the levels Saudi Arabia and its allies need to balance their national budgets, so there is plenty of scope for them to accept some combination of lower prices and/or lower output.

Prices are also well above the marginal cost of developing alternative supplies. Competition for market share can therefore only worsen while benchmark Brent and WTI prices remain above $100 per barrel.

Elevated oil prices are continuing to send a strong signal to consumers about the need to reduce demand, which is worsening the predicament for OPEC.

If Brent remains above $100 per barrel, the market will remain potentially oversupplied. OPEC's secretariat has already warned that its forecasts, based on current supply, demand and prices, "imply a further build in global crude inventories, which currently stand at high levels".

Saudi Arabia and its allies thus face a difficult decision. If they cut production and prices remain high, the market will remain out of balance, and they could be forced to cut again repeatedly, gradually eroding their market share, revenues and political influence.

TURNING UP THE HEAT

Saudi Arabia might try to spread the burden by marshalling support from other OPEC members, notably Iraq, for a policy of restricting production. But OPEC has never found it easy to reach an output agreement until prices start to fall sharply.

If the organisation is like a tea bag because it only works in hot water, the water has to be heated first. Prices are still nowhere near the level that might encourage cooperation among members or shut down surging supplies from shale formations in North America.

It is often said that the only cure for high prices is high prices (meaning that high prices are necessary to stimulate more production). But it is equally true that the only cure for oversupply is a period of lower prices to stimulate demand and switch off the cash flow and incentives for developing alternative supplies.

Whether OPEC decides to cut output this year or Saudi Arabia adjusts its exports unilaterally, the first round of cutbacks is unlikely to be the last. The policy of supporting prices will only get harder. (editing by Jane Baird)