Cutting to conquer

The 1.2 million barrels per day cut in crude oil output by the Organisation of Petroleum Exporting Countries (OPEC), spearheaded by Saudi Arabia, reflects the failure of the latter’s strategy of protecting market share at the cost of falling prices. The strategy was evolved to strangle the shale oil industry in the US which was fast emerging as a threat to the cartel. Yet, two years hence, shale oil producers have managed to ride out falling prices, aided by technology, which has helped bring down the break-even price steadily. Though the US output is down by an estimated 100,000 barrels a day, the fact is that the shale oil producers have not just survived but appropriated the role of swing producer from the oil cartel. And they have also managed to keep their finances afloat aided by cheap money sloshing around in the American financial system.

That said, the first production cut by OPEC in eight years is a significant development and the effect of the decision on oil prices — which shot up 10 per cent immediately — clearly signals that the cartel is alive and well and continues to be a force to reckon with in the market. Saudi Arabia, which has been badly hurt in economic terms by low oil prices, has taken the lead by offering to cut its output by half-a-million barrels per day. But the fact is that even after this cut, its daily output of 10.06 million barrels will be higher than the 9.5 million barrels per day that it was producing in July 2014 when the precipitous fall in prices began. A reluctant Iraq has been persuaded to also cut output, while Iran has been permitted to produce at its pre-sanction levels. The first test for prices, therefore, will be whether OPEC’s members, known for their penchant for breaching output caps, stick to the production levels set for them. The temptation to cheat for some such as Venezuela and Algeria, which are relatively smaller producers and whose economies are in the doldrums, will be high indeed.

The second test will be whether non-OPEC members, specifically Russia, support the move by cutting their own output. Though Russia has signalled its support, it has been known to break ranks in the past and importantly, all its output is piped out, making it difficult for the cartel to monitor compliance. The final test for prices will be if and when the swing shale oil producers in the US get their rigs back in action. That will cap any possibility of a rise in prices beyond the $60 a barrel mark. The bounce seen in oil prices now may, therefore, not be sustainable and the best that OPEC’s cut will probably do is ensure that prices don’t plumb back to the depths of $30-35 a barrel.

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