This deal is the beginning of the end for Opec

Posted on December 1, 2016

The deal agreed by Opec members this week will come to symbolise the passing of one of the world’s most powerful cartels. After 50 years in control of the oil price, Opec has submitted to the economic power of a much-changed global market. The deal represents the recognition of their own impotence by a group of countries that once held unchallenged power.

The agreement to cut production from January by 1.2m barrels a day raised prices on the world market by almost 10 per cent. The net result was a global price for Brent crude, the international benchmark, of $52 a barrel — up a few dollars from the previous day but still down almost 50 per cent from two years ago.

What should investors and consumers make of all this? First, consider the modesty of the increase in prices. This is not a deal capable of lifting prices to the level of $60 or $70 a barrel that is supposed to be Opec’s target. The market is obviously sceptical about delivery. Will Iran limit its production when it desperately needs increased output and revenue to sustain its economy? Will Russia actually cut output by 300,000 b/d? When did Russia last participate in an Opec quota exercise? Answer: never.

Second, take stocks — which, according to the International Energy Agency and every other independent organisation that follows the oil market, will take at least a year (probably more) to run down. If the Opec production cut were considered in isolation, this surplus might be expected to fall. But there is a surge of production coming in the next 12 months from new fields in countries outside Opec, such as Brazil, Canada and Kazakhstan. It is perfectly possible that total global production — from Opec and non-Opec states combined — will be higher next year than in 2016.

Third, consider the US shale business, which has every incentive to use the price rises to maintain and increase production. Contrary to the prophets of doom, the industry has been remarkably resilient in the past two years. There has been no collapse. Costs have been cut radically. Some companies have shut down production but they will use every opportunity to bring it back on. And the advances made in technology and productivity will spread across the world, further increasing output.

Finally, there is the view from Riyadh. The strategy of swamping the market with extra supplies to squeeze out production from competitors and to maintain Saudi Arabia’s share of the world market has failed.

What next? For all these reasons, the current deal is inadequate and will fail. The cuts will not be implemented when they are supposed to come into effect in January. Too many of the promises, especially from the non-Opec states, are too vague and the incentive to cheat is too high. Opec has no enforcement mechanism against those who break the agreement. The price will fall back, perhaps quite quickly.

Then the real choice comes for Khalid al-Falih, the new Saudi oil minister, who is much more realistic than his predecessors. To lift prices to anything close to $70 a barrel, Saudi Arabia, and Saudi Arabia alone, will have to cut production dramatically — by another 1m to 1.5m b/d, and to hold it down at that level for a year or more.

Cartels need a swing producer that has the capacity to vary production to the degree necessary to control the market and which can absorb the pain of such a move. That is what they would have done in the past, but it may now be impossible, economically and politically. Saudi Arabia cannot sustain such a sacrifice, particularly given its weak security situation and its failure to diversify its economy. If that is true, the $50 price we have today is a ceiling. Opec as a cartel is over and everyone will have to get used to the new reality.

The writer is visiting professor and chair of the Kings Policy Institute, London

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