OPEC+ Cuts Should Tighten the Market

But, what if they don't?

OPEC+ cuts – including additional voluntary cuts, most importantly by Saudi Arabia – look set to significantly tighten the oil market this year. While the pace of likely global oil demand growth is up for debate, an expansion of at least 1 million barrels per day (bpd) is widely expected, absent a recession. Non-OPEC supply growth is expected to slow significantly, most importantly in the US. Supply growth from Iran, Libya and Venezuela – countries that are not under OPEC’s quota system – is also expected to slow.

Combined, these forces are widely expected to reduce global inventories this year. In turn, this could push crude prices higher (Chart 2) – an interesting predicament here in the US in an election year – and/or allow the OPEC+ group to begin unwinding their voluntary cuts in the coming months. This view represents a broad consensus of analysts, including Rystad Energy and the three major global oil forecasters – the International Energy Agency (IEA), OPEC and US Energy Information Administration (EIA).  Additionally, ongoing conflict in the Middle East could boost prices if it spills over to impact oil exports, beyond the diversion of tankers now underway to avoid the Red Sea, or production.

And yet … market surprises have a long history of disappointing the consensus. And they could be especially impactful this year if they drive a change in the short-term strategies of the OPEC+ group and particularly of Saudi Arabia.

Last Year: A Treat That Brought a Temporary Smile to Producers’ Faces

It’s worth reminding ourselves that Saudi Arabia has held the key for the oil market in recent years. The kingdom induced the OPEC+ group to institute large quota cuts in late-2022, adding an extra 1 million bpd voluntary cut for itself on top – the famous “lollipop” offered by the Saudi oil minister. Those cuts were maintained through 2023 (and indeed, were deepened mid-year) and have now been extended through the first quarter of 2024. Those cuts left Saudi production near 9 million bpd – which, except for the extreme reductions during the Covid-19 pandemic in 2020, is the lowest in over a decade. The voluntary cuts also took Saudi’s output below, and left the kingdom holding some 3.5 million bpd of unused capacity – or more than a quarter of its total production capacity.

Yet, those large cuts have failed to boost prices, which last year fell an annual average of nearly 20%. Even with robust global demand growth, the surprising strength of production outside the purview of the supply management by OPEC+ outweighed Saudi/OPEC+ discipline.

• Production in Iran – which is a member of OPEC but not assigned a quota – grew by roughly 0.5 million bpd as sanctions enforcement weakened. Production in Libya and Venezuela – similarly outside the quota arrangement – also increased modestly.
• Russian supply came in stronger than expected. Many analysts had expected G7 sanctions to reduce output sharply in 2023, but it surprised analysts by finding new customers (and access to shipping). Russia did accept a quota that was lower than Saudi Arabia’s in mid-2023, and promised to reduce output, but compliance has remained in question – a topic we discuss further below.
• US shale operators were expected to focus on returning cash to investors rather than grow production. But while they did generate strong cash flow, they also surprised the market by delivering solid output growth. The EIA says that domestic supply grew by a very strong 1.5 million bpd last year, 600,000 bpd higher than the expectation at the beginning of the year. 

The bottom line for Saudi Arabia and the OPEC+ group last year was that temporary production restraint wound up remaining in place longer than the group had hoped for, due to stronger-than-expected supply growth elsewhere.

Will This Year Be Different?

This year, expectations are for considerably slower US supply growth – the EIA projects an increase of just 350,000 bpd. The prospect of sharply slower growth allows Saudi Arabia & other OPEC+ members to hope that they will be able to reverse their cuts and begin to regain market share over the course of this year. Rystad Energy has built in just such a projection into its outlook for this year.

For now, indications are that US supply growth will slow. Lower rig counts, plateauing productivity and continued investor pressure to maintain capital discipline and boost returns all point in that direction, with latest official data already suggesting that US production has begun to plateau.  (See chart 1)

But US shale operators have a track record of surprising the market through constant innovations to improve productivity and lower costs. With the exception of 2020 when the pandemic disrupted the industry, US production has exceeded the initial EIA forecast by an average of 300,000 bpd annually since 2012. (Chart 3). The average ‘misses’ by the IEA & OPEC have been slightly larger.

Another 0.5 million bpd upside surprise by US shale producers this year would leave the Saudi/OPEC+ coalition in an unpleasant position of maintaining their cuts for even longer and could raise questions about the sustainability of their strategy.

This comes as the kingdom requires more funds to support its economic diversification program; it ran a budget deficit last year, even with oil prices above $80 per barrel. The IMF estimates the Saudi budget’s breakeven oil price is $86 per barrel. Bloomberg estimates that including the spending plans of the Public Investment Fund – its sovereign wealth fund – would drive that breakeven up to $108. To be sure, while the country’s revenue needs are robust, its underlying fiscal condition is dramatically better than it was in the late 1990s, when public debt as a share of GDP briefly exceeded 100 percent.

Relatively inelastic global oil demand and (non-Saudi) supply mean that the revenue-maximizing strategy for Saudi Arabia in the short term is to restrain supply and go for higher prices. That is – in the short-term, the percent of production restrained is less than the resulting percent boost in prices. Of course, the strategy works even better when the pain of cutting production is shared by bringing other countries into the quota regime—even though that also complicates decision-making and encourages cheating or breaching their quota limits. The major innovation in the Saudi/OPEC market management strategy in recent years has been the creation of the broader OPEC+ group in 2016, which added Russia and other non-OPEC countries to the group’s production targets and expanded the market share of participating countries to about 50% – close to what it was for OPEC during its heydays in the early 1970s.       

But cutting production to boost prices has proven to be difficult to sustain over time. It leaves countries with large amounts of spare capacity, raising the risk of cheating, or simply quitting the effort, as Angola has recently illustrated. Moreover, it invites investments into competing supply and weighs on demand growth. As a result, the cooperation occasionally breaks down and the lead producer tries to give others what John Rockefeller once called “a good sweating” – that is, a price war. OPEC, led by Saudi Arabia, did this in November 2014 after losing market share over several years to US shale producers, and to Russia in the early days of the pandemic in 2020 when the latter balked at aggressive production cuts.

Alternatives for 2024: More Treats, Or a Good Sweating?

So, could the kingdom engage in a price war this year if US production once again surprises to the upside? The hoped-for reversal of the OPEC+ cuts could also be delayed by weaker-than-expected demand growth, or supply surprises outside the US. Or would it rather extend, or deepen, its existing cuts in an effort to support prices?

A price war could be even more complicated for the kingdom to manage this time around. In addition to its own growing revenue requirement, the kingdom now has to worry about its new oil market ally Russia, which is also under pressure to boost oil revenues to fund its war in Ukraine. The Saudi-Russia oil nexus has been one of the dominant features of the market in recent years – a move that surprised many who remember the longstanding Russian resistance to participate in production cutting exercises. Russian compliance has always been a question mark: Most recently, Russia said its participation in the cuts was through exports rather than production, and applied it to both refined products as well as crude, making verification more difficult.

Extending the existing production cuts beyond the first quarter could support prices, or deepening them, would minimize Saudi Arabia’s domestic budgetary discomfort and keep relations with Russia on an even keel. But such a move would come at the potential cost of encouraging additional investment from US shale and other global suppliers at a time when many, but not all, forecasters expect a peak in global oil demand. And that’s a prospect that would be hastened by a high-oil price policy from the OPEC+ group. In such a case, ‘temporary’ production cuts could become a more durable and unpleasant fact of life.

Bottom Line: Hope for the Best, Prepare for the Worst

If US production growth is likely to run out of steam, maintaining cuts until the market tightens is clearly the least painful short-term strategy. That’s where the consensus is currently. 

But how would the kingdom react to continued, unexpected weakness in global fundamentals?  Would it bear the short-term pain of a price war to better position itself for the medium term?  Or would domestic revenue needs and its relationship with Russia mean offering additional “lollipops” to the market by extending, or deepening, the existing production cuts?

The consequences of these choices would be felt across governments, boardrooms, kitchen tables and polling stations around the world, not just in the capitals of Riyadh and other OPEC+ countries.  

This commentary was originally published by Rystad Energy and is reproduced here with permission.