Saudi Arabia’s announcement that it will reduce oil output by 1 million barrels per day in February and March has boosted prices and helped paper over divisions within the producer alliance, at least temporarily.
The unilateral cut, announced on Tuesday, reaffirms Saudi Arabia, rather than the Organization of the Petroleum Exporting Countries (OPEC) or the wider OPEC+ alliance, is the true swing producer in the oil market.
The unilateral cut was not widely anticipated, and marks a shift from Saudi Arabia's previous insistence of not acting alone, but it has a number of advantages for the kingdom at this point:
* By acting unilaterally and presenting the reduction as voluntary, Saudi Arabia has maintained a united front with other OPEC members and Russia, leader of the OPEC+ partners, despite disagreements over strategy.
* The cut should allay criticism from other members of OPEC+, including the United Arab Emirates, that Saudi Arabia’s production baseline from which previous cuts were calculated was too high.
* The cut burnishes Saudi Arabia’s credentials as a responsible market manager, at a crucial moment when the kingdom needs to build an effective diplomatic relationship with the incoming Biden administration in the United States.
* The cut should offset the risk of consumption recovering more slowly this year as a result of the continuing epidemic and a lingering downturn in the business cycle.
By removing an extra 60 million barrels from the market, the cut should ensure inventories continue to fall even if the epidemic surges again, vaccine deployment is slow, and international aviation remains restricted.
Timing is critical. The cut will help to bridge the difficult first quarter, when consumption is always seasonally low and there is the greatest danger this year from the virus and vaccine delays.
Before the announcement, both prices and calendar spreads had shown signs of coming under pressure as the number of coronavirus infections has increased across Europe and North America.
But the surprise cut has stabilised Brent prices at more than $50 per barrel, and deepened the backwardation in the futures market, with the sharpest price increases for deliveries in the first and second quarters of the year.
SWINGING AGAIN
Saudi Arabia can always lift prices and push the futures market into backwardation if the kingdom is willing to reduce its own output sufficiently (https://tmsnrt.rs/3pRs3C4).
But the kingdom has been ambivalent about its role of swing producer, at times offering voluntary cuts, at others insisting the burden must be shared proportionately by all OPEC producers and their external allies.
Between July 2014 and December 2016, and again in March and April 2020, Saudi Arabia fought volume wars, insisting that it would not reduce output unless other countries made proportionate cuts.
But there have also been times when the country has been willing to reduce its production unilaterally, either officially or informally, to expedite market rebalancing, most recently in June 2020.
Saudi policy has oscillated between accepting and rejecting its swing producer role, in the same way its policy has alternated between focusing on protecting prices and defending market share.
The kingdom’s strategy changes have been mostly a response to the cyclical behavior of oil production, prices, and inventories, but they have also contributed to that cyclical instability.
STRATEGIC CHOICE
The most recent volume war broke out in March 2020 when Brent was trading around $55 and the six-month calendar spread was hovering between backwardation and contango.
Conflict erupted when Saudi Arabia and Russia disagreed over whether to continue restricting production (Saudi Arabia’s preference) or boost output to defend market share from U.S. shale firms (Russia’s preferred course).
In December, with prices nearing the same level as March and the futures market again in a flat structure, these disagreements re-emerged, but this time the response from Riyadh has been different.
Saudi Arabia has chosen to sidestep the divergence by unilaterally cutting its own production to boost prices further, without insisting cuts be shared by Russia and the other members of OPEC+.
The kingdom’s production cut will also throw a lifeline to U.S. shale producers, ensuring drilling rates continue to recover, and should help to stabilize their production this year.
In the short term, the unilateral cut has protected prices by pushing disagreements about market share into the future.
As global oil consumption recovers after the epidemic, and prices and spreads move towards a new cyclical peak, cohesion within OPEC+ will weaken further, and other members are likely to start raising their output.
Saudi Arabia will face a tough choice between continuing to restrain its production or trying to win back some market share. But those decisions have been postponed for another day.
(John Kemp is a Reuters market analyst. The views expressed are his own; Editing by Barbara Lewis)