(John Kemp is a Reuters market analyst. The views expressed are
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By John Kemp
LONDON, Sept 30 The Organisation of the
Petroleum Exporting Countries surprised oil traders and analysts
by announcing a production deal following a hastily convened
extraordinary meeting in Algiers on Wednesday.
The Algiers agreement seems to have been designed to
engineer an increase in prices by changing market sentiment
rather than reducing the physical supply of crude.
OPEC issued a statement of just under 700 words following
the meeting. The operative parts, which consisted of two
paragraphs or 105 words, recorded two decisions:
(1) OPEC's 14 members committed themselves to a collective
production target ranging between 32.5 million and 33.0 million
barrels per day.
(2) A high-level committee will be established to study and
recommend the implementation of the production level by
individual member countries and consult with non-OPEC oil
The production target was the first time that OPEC members
had committed themselves to an overall output level since June
But the critical question is whether the production target
will affect the actual number of barrels being marketed by the
Should the collective production target be characterised as
a cutback, a freeze or continued, albeit restrained, growth?
The answer depends on the baseline against which the target
is measured and what would have happened in the absence of a
OPEC members produced an average of 33.24 million barrels
per day in August, according to estimates by secondary sources
published in the organisation's own monthly oil market report.
If the production target is compared with the production
level in August, then it represents a cut of somewhere between
250,000 and 750,000 barrels per day.
But OPEC members, led by Saudi Arabia, boosted their
production during the summer, in part to meet strong domestic
demand for power generation.
Saudi Arabia's own oil production showed a seasonal increase
of around 400,000 barrels per day between May and August ("Saudi
Arabia isn't flooding oil market ahead of freeze talks",
Reuters, Aug 23).
In most years, Saudi Arabia's output has been reduced once
the the summer heat is over and the need for direct crude
combustion in power plants falls (tmsnrt.rs/2dwtfXj).
Before the summer, OPEC members were producing around 32.25
million barrels per day, with an extra 200,000 barrels per day
being produced by Gabon, which rejoined OPEC on July 1.
If the production target is compared with pre-summer
OPEC+Gabon output of 32.5 million barrels per day, it represents
a production freeze compared with the first half of 2016 or even
a slight increase.
So the fairest way to characterise the output deal is
probably as a production freeze, rather than a production cut.
SAUDI SHOWS FLEXIBILITY
Following the agreement, Saudi Arabia will reduce its crude
production after the summer, which it would probably have done
in any event, based on past behaviour.
But the target creates some limited flexibility for Iran,
Libya, Nigeria, which claim their production has been
temporarily disrupted, to pump more in the months ahead.
The output deal will therefore not actually remove any
barrels of oil from the market in the remainder of 2016 and
Some OPEC members are already disputing the details. The
collective target does not include individual country
Iraq has said its output is being under-estimated by the
secondary sources and it will not be bound by the ceiling unless
its baseline is revised.
But OPEC is hoping that continued growth in oil demand
coupled with an output freeze will create a deficit and start
drawing down the excess stocks that have accumulated since 2014.
The deal represents a significant shift by Saudi Arabia
which had previously insisted it would only agree to a freeze if
it was joined by all OPEC and major non-OPEC producers.
Saudi Arabia has now said other OPEC members, including
arch-rival Iran, will be free to produce "at maximum levels that
make sense". Non-OPEC producers, including Russia, are not
formally associated with the freeze.
In that respect, Saudi Arabia seems to have gone to Algiers
determined to announce an agreement, and willing to show
whatever flexibility was needed to obtain one.
STRATEGY WAS NOT WORKING
The kingdom's change of heart seems to have come from a
realisation that low oil prices were not rebalancing the market
in the way that official hoped ("Economics drove Saudi OPEC
move", Wall Street Journal, Sep 29).
Since 2014, Saudi policy has aimed at protecting its share
of the crude market while allowing prices to find their own
Lower prices were expected to curb production by other
producers with higher costs while improving the kingdom's
However, while shale production in the United States has
been falling since early 2015, it has been more than offset by
increasing output from OPEC members.
Oil consumption has grown rapidly but not fast enough to
soak up all the extra oil being supplied and start drawing down
stockpiles in a meaningful way.
The kingdom's strategy assumed 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
Saudi policymakers thought likely in 2014 and shows no sign of
Falling oil revenues have pushed the kingdom's economy close
to or into recession and are requiring deep cuts in government
spending on infrastructure as well as social payments and
Saudi Arabia's foreign reserves have declined by $182
billion, 24 percent, since August 2014 (tmsnrt.rs/2dACZnm).
Reserves declined by $53 billion in the first seven months
of 2016, despite big cuts in government spending and attempts to
raise non-oil revenues (tmsnrt.rs/2dAENgh).
The kingdom still has reserve assets valued at $564 billion
and substantial ability to raise more money by issuing debt.
But it also needs to preserve a large reserve cushion to
maintain confidence in the riyal's peg to the U.S. dollar, limit
capital flight and avert a run on the currency.
The kingdom's production policy was ultimately on an
unsustainable financial course, so policymakers, under a new oil
minister, have modified it ("Saudi Arabia's oil policy could
become more transparent", Reuters, May 9).
The decision almost certainly includes a strategy shift at
the top of the Saudi administration, where Deputy Crown Prince
Mohammed bin Salman has emerged as the key decision-maker.
MODEST PRICE BOOST
Prince Mohammed indicated earlier this year it did no matter
for the kingdom whether oil prices were $30 or $70 per barrel.
But in recent months officials have indicated they believe
prices are unsustainably low and want them to rise.
The agreement was meant to signal a new Saudi willingness to
temper its production even if other members of the organisation
manage to increase their output marginally.
The Saudi calculation seems to be that the kingdom will gain
more from an increase in prices than it will from any reduction
in the number of barrels sold.
In any event, Saudi policymakers probably calculate,
correctly, that rival producers have little capacity to raise
output in the short term.
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.
Libya is likely to remain a failed state. Nigeria is
struggling to re-establish security in its oil-producing areas.
And Venezuela remains in the throes of a prolonged internal
political and economic crisis.
Saudi Arabia is unlikely to lose much market share to other
members of OPEC if it limits its own production to the level
achieved in the first half of 2016.
Limiting its own production could accelerate the oil market
rebalancing process while leaving Saudi Arabia free to increase
output later once stocks have started to come down.
The main threat comes 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 but the
sector remains under intense financial pressure.
The Saudis probably calculate that an increase in prices to
$50-60 per barrel would bring useful extra revenue without
stimulating too much extra shale production.
The Algiers agreement is a gamble that Saudi Arabia can
achieve a modest boost in prices and revenues by freezing
output, talking up the market and accelerating the rebalancing
process, without losing too much market share.
(Editing by William Hardy)