Why Saudi Arabia Let Oil Prices Fall – 6/14/16

Since the fall of oil prices to devastatingly low levels, Saudi Arabia has fought other OPEC members on the best strategy to reverse the trend. Members such as Venezuela were desperate for output reductions or freezes, while Saudi Arabia gave only superficial encouragement before essentially sabotaging freeze talks in Doha with its demanding that Iran join any agreement.

The kingdom’s reluctance to tamper with oil markets is based on a simple economic argument: oversupply cannot be resolved by propping up prices. The two main contributors to the glut – explosive growth in U.S. shale-oil production and weakening Chinese demand – were never in doubt, so it is understandable that any action would have to address the effects of one or the other. Since replacing China’s insatiable appetite is beyond any country’s power, solutions would have to reduce the flood of U.S. oil.

Propped up prices were only going to make the glut last longer. U.S. shale-oil producers proved that they could survive low prices far longer than analysts expected and OPEC cuts to output would have only encouraged more pumping from shale at the expense of Saudi Arabia’s market share.

With prices recovering following a bruising month for U.S. output, Saudi officials can finally say their strategy is working with some confidence. Oil production outside OPEC is headed for a huge drop as the U.S. shale-oil boom is ending, according to IEA forecasts, while the Energy Information Administration estimates U.S. output has fallen to its lowest since September 2014. At the same time, oil prices have risen from mid-$20 a barrel to about $50 a barrel.

“It might not look a victory compared with when oil was $100 a barrel, but the Saudi strategy is working as you’ve got significant production declines showing up in a lot of places, and prices are grinding higher,” said Seth Kleinman, head of energy research at Citigroup Inc.

Low prices took a heavy toll on budgets and reserves, but the strategy probably preserved Saudi Arabia’s future revenues far better than cutting output and effectively subsidizing U.S. competitors. The next OPEC meetings are likely to be less contentious so long as supply and demand continue moving back into balance.

“The Saudis might be concerned that if prices go a little higher and sustain it, that could nip the re-balancing in the bud just when it’s getting going,” said Mike Wittner, head of oil market research at Societe Generale SA . “I don’t know they have a whole lot of incentive to particularly do anything.”

Even if Saudi Arabia had some incentive to coordinate with other OPEC members, there is no guarantee it actually would. The failure to complete an output freeze accord in Doha illustrated just how dysfunctional OPEC had become when the deal fell apart at the last minute on Saudi Arabia’s Deputy Crown Prince Mohammed bin Salman insisting that regional rival Iran would need to join. In the midst of recovering from trade sanctions that crippled its oil output, Iran refused with no small amount of indignation.

“The coming period is going to be a real test of whether or not OPEC is still alive,” said Mohammad al-Sabban, a former senior adviser to the Saudi oil ministry.

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