Saudi Arabia’s Next Oil Move
The sharp decline in the Brent price to below $60/barrel and the weakening of the oil demand outlook due to the US-China trade war has brought to the fore the issue of Saudi Arabia’s next move. There have been multiple media reports indicating that Saudi Arabia would not tolerate the latest price slide and that the Kingdom has approached other OPEC members to discuss possible steps to arrest the decline in the oil price. To most analysts and investors, this signals that Saudi Arabia is willing to cut its output further to try to maintain a floor under the oil price regardless of the nature of shocks hitting the market.
Given that demand shocks are more persistent and that the trade war could take a long time to resolve with resulting repercussions being felt for many years, the required cuts may have to be deeper and maintained for longer. Saudi Arabia also faces the challenge of convincing other OPEC+ members to implement deeper cuts, especially given that the pool of those countries that can cut is small. Cutting unilaterally risks distorting other OPEC+ members’ incentives, shifting the entire burden of rebalancing to Saudi Arabia. But even if Saudi Arabia does cut output unilaterally, the oil price response may be muted in which case the Kingdom may end up with lower revenues.
But if cutting output may not necessarily lead to higher revenues in the current context, could a policy of increasing output result in higher revenues in the medium term? In other words, could the revenue calculus facing the Kingdom change in the face of a negative demand shock? If the numerous reports that US shale is on its last legs and ‘the time for US shale is up’ are correct, and given that most of the growth in non-OPEC supply originates from the US, then it is straightforward to construct a scenario in which higher Saudi output would accelerate the slowdown in US shale and Saudi Arabia’s medium term revenues would rise as the Kingdom could increase its market share without negatively impacting the price. The reality however is that the US shale response is not yet understood and as recent history has shown, its performance can’t be predicted with any accuracy and it could be that many of the reports highlighting the extent of the current weaknesses and the decline in productivity of US shale are exaggerated. As such, the costs of undertaking such a strategy could be high while the benefits are highly uncertain.
Given the risks and costs associated with each of the above options and the wide uncertainty regarding the size of the shocks and their persistence, the most likely scenario is for Saudi Arabia will not to deepen its cut further nor seek a new OPEC+ agreement for deeper cuts, in the hope that slower US shale growth and geopolitical outages will outweigh demand weakness and stocks will fall in the second half of the year. Looking at current market fundamentals alone, there is no urgent need to shift gears for now: the overall compliance within OPEC+ is robust, supply outages remain high, and US shale production growth has been showing signs of deceleration. Thus, on the supply side, almost everything is going in the Kingdom’s favour. The problem lies elsewhere and supply measures alone can’t counter the broad macro factors. Sometimes the best course of action is to do nothing.
However, looking ahead into next year, the challenge of balancing the market gets more difficult if demand weakens further and Saudi Arabia may need to reconsider its policy. If expectations of a sharp fall in demand growth do materialise, it should consider all options as the trade-offs and the revenue calculus could change. However, until the divergence in expectations narrows and the macro sentiment stabilises, OPEC may find that its best option is to ‘stay on the sidelines’ but prepare for the increasing possibility of harder times ahead.