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OPEC Production Strategy: Decisions and Consequences

OPEC's refusal to cut production in an attempt to preserve market share has had unwanted consequences – significant negative impacts on producer countries, the erosion of Saudi welfare reserves and the generation of internal divisions within the institution itself.

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Had Horst Mayer, the General Manager at the Grand Hotel Wien, wheeled a crystal ball on a gilded trolley into the Nov 27 2014 OPEC meeting, what are the chances that the group would have chosen a different course of action from the one we’re now witnessing? And if you had a crystal ball now what will come first – a cut in production or demise of the group?

At the time of the November meeting, Iran, Algeria and Venezuela all made the case for the group to do what it had done in times of difficult market conditions – cut production. The lion’s share of this would have fallen to Saudi Arabia, which would have lost both money and market share to its own intergroup rivals.

Instead (and predictably under the direction of Ali al Naimi), it refused to budge and chartered a course that sought to flood the market, drive down price and force out its competitors. The logic was that once they had gone so too would the excess capacity and prices would right themselves.

Things didn’t turn out quite as expected. There has been a substantial reduction in the number of rigs used by shale drillers in the States, but the total wipeout did not happen. For some including EOG Resources which is one of the largest producers of shale, output is expected to have dropped over the summer but others such as Pioneer are confident they’ll increase output over the remainder of 2015 and into 2016 even at reduced prices. A large part of that resilience is down to improving technology which enables more efficient extraction and lower production prices.

It’s now emerged that had OPEC sacrificed just 5% of its market share at that time, price would likely have remained above $100pb, long enough to ride out the threat of the US shale revolution. In 2014 the OPEC average pb was $104.62. In 2015 Q1 the price fell to $52.03 – a drop of 50%.

For some OPEC members it is a price they appear content to pay. Saudi Arabia which leads from within finds support from UAE, Kuwait and Qatar which now account for just over 18m bpd. But the losers are Iran, Nigeria, Algeria, Libya and Venezuela, and they’re not being passive anymore. As one commentator puts it, the strategy is ‘tearing OPEC apart from within.’

In a recent letter to OPEC’s secretariat Algeria’s oil minister requested action but stopped short of asking for a production cut. Venezuela which is arguably the worst hit of the group’s members saw officials writing before the last OPEC meeting in June to call for a change in strategy. Iran which has been bullish about returning to pre-sanction output levels since signing on the dotted line over the nuclear deal, has also said there ought to be an emergency meeting of the group before December to discuss the immediate plan of action.

However with the Saudi government looking at ways of reducing state spending in the Kingdom the indications are that al-Naimi has no plans of changing course.

Will those not in al-Naimi’s clique accept the target output levels? Iraq has been producing 4m bpd and has signalled intentions to increase that by 1m in a few years. Iran too has been bullish about its ambition to return to pre-sanction levels of output. This assertive rejection of OPEC’s central command gives rise to questions about its future relevancy. “They’re still holding meetings but if the meetings are not about controlling output then they don’t matter in the same sense that they’ve mattered for 40 years,” warns George Perry at Brookings Institute in Washington. “Now they’re just forcing someone else to do the cutting.”
Ed Morse of CitiGroup in New York goes further, who is quoted on as saying, “It’s too early to write the obituary for OPEC but it’s moaning and groaning on its deathbed.”