The Saudis Won't Let Oil Free-Fall

With a few exceptions, the consensus emerging from last week’s inconclusive Organization of Petroleum Exporting Countries meeting is that if OPEC is not dead, it is at least in a coma.  This may be a reasonable judgment based on the group’s ability to take collective action on a production cut to bolster the price of oil in the short run. 

But a smarter and more accurate conclusion would be that OPEC, at least for the foreseeable future, is no more than Saudi Arabia. And while the Saudis are content with the global oil prices for now, there are political -- if not economic -- reasons they could be spurred to act against even greater declines in the months ahead.

Oil Prices

It's fairly obvious why no deal was made to cut production when the OPEC oil ministers met in Vienna last week.  Many of the group's top producers feel they have good reasons to be exempted from any OPEC-wide cut. Iran’s current production is already well below its quota, due primarily to Western sanctions. Iraq, which has not had a quota on production since the Persian Gulf War of 1991, is fighting Islamic State and still trying to rebuild after decades of sanctions and strife. Libya now has two battling governments to support with its oil revenue, and is producing a fraction of traditional quantities. (Interestingly, both Libyan governments wanted to send oil ministers to Vienna, although only one was allowed to participate.)  Nigeria is facing a rising threat from Boko Haram. And the list goes on. 

The upshot is that unlike in years past, few OPEC members have the leeway in their budgets to take action that risks lowering revenue.  Moreover, there is a lack of trust among the nations that their fellow members will keep to their commitments.  For many countries, it would be hard to resist the urge to maintain production in the hopes that others will cut theirs.

In contrast to other OPEC members, almost every one of which has a fiscal break-even price above today’s $71 a barrel for Brent oil, Saudi Arabia is comfortable with the current slump.  It is in a strong economic position:  Its reserves are close to $750 billion and its national debt is practically non-existent.  The budget is laden with big infrastructure projects, but many could be cut if necessary.  The kingdom can weather low prices so as to protect its market share and wait for new market dynamics to settle out.

There are other explanations for what appears to be Saudi complacency about the price. Some analysts, I believe, over-emphasize the Saudi desire to challenge U.S. shale production --particularly given that increased American oil production over the past few years has eased what would have been enormous pressure on Saudi Arabia to bolster its own production capacity, at great cost. That said, Saudi decision-makers might be happy to put another dart in the efforts to bring the shale-oil revolution global, something that has already been moving more slowly than expected.  The Saudis are also perfectly content to see Iran and Russia struggling domestically.  And then there is the fact that it is easier to make no decision than to change course, something which should not be underestimated in the Riyadh government, where decision-making has become notoriously slow. 

Most important, perhaps: The Saudis vividly remember the 1980s, when they cut production and lost a huge portion of their market share, without substantially affecting the global price of oil.  They probably have even less confidence today that production cuts would have the desired impact than they did back then. 

First, Saudi production (and that of OPEC) as a percentage of the global market is declining, largely on account of new sources in the Americas.  Second, now that there is a non-OPEC supply that is sensitive to price (which was not the case in the past), any OPEC reductions would likely spur increased foreign supply; this means that production cutbacks would need to be deeper than ever before to have the same effect on price. And, finally, the Saudis are aware that the real oversupply in the market is not of their heavy crude, but of the lighter, sweeter variety that used to be absorbed by U.S. markets before the tight-oil boom there.

All these reasons suggest that nobody should hold her breath for the Saudis to make a cut in production.  And, without a Saudi willingness, there will be no OPEC action.  In all likelihood, Saudi Arabia arrived at the OPEC meeting with no intention to cut production, which predetermined the outcome. 

All that said, however, there is another important question: Will the Saudis be content to let the price of oil free-fall if supply-and-demand fundamentals continue to push it significantly downward? 

The answer: Probably not.

While the Saudi economic cushion gives the kingdom tremendous economic leeway, there are political considerations that could make the government nervous about even-lower prices. To begin, Riyadh has to be sensitive to how its own citizens perceive lower oil prices.  Even if the nation can weather the economic fallout, falling prices could translate into a perception among the Saudi people that the monarchy has lost control of the oil market, and inject greater instability into an already uncertain domestic political environment. 

Moreover, the monarchies of the gulf have been fortunate in staving off the political revolutions that upended the neighboring Arab republics -- in large part by increasing public spending in a big way.  Saudi Arabia will be sensitive to whether low oil prices could strain its social contract with its citizens; it will also be concerned that any financial difficulties of its monarchical neighbors could bring about political instability in the region.  Any turmoil in Kuwait, Oman or the United Arab Emirates could lead Riyadh to reconsider the status quo.  Right now, these countries are in good shape. But, as the revolutions of 2011 demonstrated, small events can have big consequences. 

Given the big increases in global supplies and cooling demand in Europe and elsewhere, it makes sense to prepare for a period of lower oil prices. And, given the internal dynamics of OPEC, it is probably correct to dismiss the possibility of collective action there to change the global dynamic.  But don't write off the possibility of action by Saudi Arabia, which will have its own calculations, though they may be hard for outsiders to discern.