Saudi Arabia’s about-face

About a week ago, Saudi Arabia brokered an agreement among oil producing countries to cap their aggregate output of crude at 32.5 million barrels daily.  This will require daily liftings to be reduced by 1.2 million barrels.  Of that 1.2 million barrels in cuts, the Saudis themselves will account for 486,000, or just over 40%.

This Saudi decision flies in the face of the kingdom’s previous policy and its experience in the 1980s, when it repeatedly reduced production in a vain attempt to stabilize prices.  What happened back then?   …other OPEC countries, with more pressing needs for cash and with relatively short-lived reserve bases (so playing a long game made little sense, just as today), failed to make the output reductions they agreed to.  More than that, they boosted their liftings instead in amounts that more than offset the Saudi cutbacks.  So prices continued to fall, and for years afterward Saudi Arabia lost access to long-time customers.

Over the past two years, because of the bitter experience of the 1980s, Saudi Arabia has refused to reduce its output despite pleas from other OPEC members.  It  has even increased production a bit.

…until now.

What should we make of this about-face?

The superficial arithmetic for Riyadh is clear–reduce output by 5%; the price per barrel rises by 10% as a result; total revenue rises by 5%.  That’s assuming no cheating by other parties.  But in the case of every economically-driven commodities cartel, cheating always happens.  And the Saudis know that OPEC proved itself no different from other cartels 35 years ago.

 

What’s interesting about this case is that for us as investors situations like these, where we have imperfect information, arise more often than we would like to believe.  Rather than obsessing about what we don’t know in these cases, it’s important to see what conclusions we can draw from what we do know.

In particular:

–Saudi Arabia simply can’t have forgotten about its experience in the first half of the 1980s.  It must believe that eventually some parties will fail adhere to their production quotas.  But it must have some reason to believe that this won’t happen immediately

–it’s possible the kingdom thinks that with supply and demand are almost evenly matched, output reductions will cause the crude oil price to rise substantially.  The price rise will ward off cheating

–the Saudis must also think that what they’re doing now is a better strategy for them than that of pumping full-out and keeping prices low.  Why should this be?  My first thought is that Riyadh’s finances are not in strong enough shape to continue to endure $40 a barrel oil

–the Saudis must realize as well that $50+ a barrel will reinvigorate the shale oil industry in the US, capping any possible price rise.  On the other hand, keeping prices at, say, $40 a barrel won’t make shale oil go away.  The industry will simply lie dormant for a while, ready to spring to life again when prices are higher.  On the other hand, they may no longer believe that they can destroy the shale oil business forever by keeping prices low.  they may even fear that technological advances and cost-cutting will make shale viable at $40 if they are allowed to take place.  So, counterintuitively, the best strategy for combating the threat of shale may be to discourage the development of such new techniques by keeping prices higher

my take

Buy shale oil and monitor OPEC closely.

 

 

 

 

 

One response

  1. On the other hand, they may no longer believe that they can destroy the shale oil business forever by keeping prices low. they may even fear that technological advances and cost-cutting will make shale viable at $40 if they are allowed to take place. So, counterintuitively, the best strategy for combating the threat of shale may be to discourage the development of such new techniques by keeping prices higher
    – i agree with you on this point. From production freeze in Feb to production cut now. And after US production has dropped but Permian production is now rising again. Saudi decisions have been quite strategic, apart from the pressure from fiscal breakeven.

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