Oil: The Saudi Two-Stage Floor Strategy

Published on November 26, 2018

A bit of a bounce back in crude oil prices this morning after steep plunges in recent weeks should provide some relief to Saudi oil officials preparing what we would describe as a two-stage strategy of output cuts to put a floor under oil prices through the turn of the year and set the stage for a modest rise in prices — and the Kingdom’s oil revenues — next year.

*** It is our sense that the first phase of the Kingdom’s oil strategy will play out at the G20 meeting that starts this Friday. Indeed, it is the primary reason the embattled Saudi Crown Prince Mohammed bin Salman is going to Buenos Aires and bringing energy minister Khaled al-Falih with him. The objective is twofold: to strike an understanding with Russian President Vladimir Putin on committing Russia to at least token cuts in crude output at the December 6 OPEC-plus meeting, and, from President Trump, a reprieve from threatening tweets. ***

*** With the way cleared at the G20 meeting, the second stage of the Saudi oil strategy will be a credible headline of output cuts at the crucial OPEC meeting in Vienna on December 6. The Saudis are acutely aware they will have to deliver the bulk of the cuts, and we understand they will invariably increase the 500,000 bpd in cuts already indicated to as much as 750,000. With an additional 250,000 to 350,000 bpd in cuts from Kuwait and the United Arab Emirates, OPEC would be within range of a targeted minimum of 1.2 million bpd in cuts starting in January. ***

More Cuts in February If Needed

In addition, the Saudis are believed to be keeping additional potential cuts in output in mind by February or March after they see how oil prices respond to the OPEC cuts and the impact of the Iranian sanctions, as well as a better sense of global demand going into the seasonal build up in the second quarter.

The bet, for now is that further cuts that would bring them to or just below the 10 million bpd mark in output may not be needed if prices stabilize by then and even begin a modest rise. Importantly, the recent establishment of a more flexible monitoring committee, with a new secretariat in Vienna and headed by Russia, will start making recommendations on production cuts or increases on a “consensus basis” from January.

The new monitoring process will provide Saudi Arabia with the necessary cover to take action quickly instead of waiting for an unanimous OPEC ministerial decision — in particular, undercutting Iran’s ability to veto OPEC moves.

The room for the Kingdom’s cuts in output was built into the surge production in November, which the Saudis claim reached as much as just shy of 11 million bpd in November after having reached 10.72 million bpd in October. The November surge is unsustainable, however much the Saudi oil officials claim a sustainable capacity in excess of 12 million bpd.

But coupled to the shifting market sense of lower oil demand next year — a forecast shared by the Saudis, which accounts for their reluctance since summer to increase output to the extent they did — the higher output in October and especially in November no doubt played a contributing role in pushing crude prices sharply lower.

Of course, the Saudi surge was also timed to offset the loss of Iranian crude exports as the US-orchestrated sanctions were expected to further erode Iranian crude exports reaching the market. President Trump’s sudden reversal to allow so many exemptions to the oil sanctions meant the loss of Iranian crude never materialized, adding to the current oversupply.

Alarm Bells in Riyadh

The dramatic price collapse set off the alarm bells in Riyadh, where the hard realization sank in that they would pay in lost revenues and especially lost standing when they abandoned their own hard-negotiated OPEC plus Vienna Framework to increase output under pressure from President Trump.

They now need OPEC again, but Saudi credibility and influence within OPEC and the non-OPEC oil producing participants in the 2016 Vienna framework has been gravely weakened in the wake of the Kingdom’s alignment with President Trump.

Few oil producers are willing to agree to proportioned output cuts, while Moscow, whose participation is considered essential by the Saudis – as we understand – is still unwilling to give Riyadh a commitment to output cuts. MbS hopes to change that, at least in terms of verbal support for output cuts, in his meeting with Putin on the sidelines of the G20 meeting.

Seeing how weakened Riyadh is by the complicity of the Crown Prince in the murder of Jamal Khashoggi, however, we are unsure Moscow will add to collective cuts much beyond — as is likely with Iraq — rhetorical support with promised cuts against “future” projected output.

It is uncertain whether the OPEC cuts, even with the hard barrel cuts by the Kingdom and its Gulf allies, will be enough to stabilize oil prices at a higher sustained range. But Riyadh is understood to be seeking average crude prices around a $70 benchmark for next year.

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