Monday, July 31, 2017

OPEC Has A Crippling Problem: Its Members Can’t Stop Pumping

Eight months after a landmark deal to cut oil output to force prices up, big budget obligations drive members to keep producing.


By Benoit Faucon, Lynn Cook, Summer Said, and Georgi Kantchev
The Wall Street Journal
July 31, 2017

OPEC, the once powerful oil cartel, is struggling to hold the line in a make-or-break fight to limit oil production, prop up crippling low prices and prove its relevance.

Why? Its members are addicted to oil.

Eight months after the Organization of the Petroleum Exporting Countries announced a plan for its 14 members and 10 allied countries to withhold almost 2% of the world’s oil every day to boost prices, seven of the 11 OPEC members that pledged to cut appear to be producing more oil than promised.

Crude prices have actually fallen, by 7.6% to $52.52 a barrel, since the beginning of the year—half what the cartel called a fair price just three years ago and a level that some say is here for the long term.

Previously, low production costs meant OPEC members profited even when oil prices fell. These days, members have ramped up government spending to keep populations happy and cover military expenses, and don’t have a cushion to let oil revenues slip. Their strained budgets can be covered only through increasingly high prices per barrel, and if prices are low they need to produce more.

The inability to control output poses a potentially existential threat to OPEC’s influence. The longer prices remain low, said Helima Croft, the global head of commodity strategy at RBC Capital Markets and a longtime watcher of the cartel, “the harder it is to make the case to the most cash-strapped producers that they are ‘better together.’ ”

Tensions were laid bare last week in St. Petersburg, where OPEC and its non-OPEC allies discussed why output was going in the wrong direction.

Russia aimed to boost camaraderie with a visit to the Hermitage museum and a picturesque evening cruise on the Neva River, where ministers donned matching hoodies bearing the logo of the city’s soccer team, FC Zenit.

But during the weekend, Saudi Arabia’s energy minister, Khalid al-Falih, and other oil officials holed up in a hotel conference room at the Four Seasons calling other OPEC ministers—including those in Iraq and the United Arab Emirates—demanding to know why they weren’t cutting production as much as promised, according to people familiar with the matter.

“Some have underperformed. We have talked to them,” Mr. Falih told reporters, adding he didn’t “mince words.”

Iraq denied it wasn’t meeting targets and said OPEC was getting bad information.

OPEC has been under pressure from U.S. shale producers, who since about 2008 have helped to nearly double U.S. oil production.

The output has stolen market share from the cartel’s members and pushed prices lower. OPEC’s share of the global oil market has shrunk to 40% today from 55% in the early 1970s, when its embargo on sales to the West quadrupled oil prices in six months.

The dynamic working against OPEC is that, collectively, its members need the highest oil prices of any industry player—more than companies such as Exxon Mobil Corp. , Royal Dutch Shell PLC and most U.S. shale producers, according to Goldman Sachs .

For decades, OPEC was the low-cost producer of oil. During the boom years of 2011 through 2014, OPEC members, which largely fund national spending with oil revenue, could balance their budgets with oil prices $10 to $40 a barrel less than most oil companies needed to fund their spending and pay dividends. Today, OPEC needs $10 to $20 a barrel more than Big Oil and U.S. exploration and production outfits, the investment bank said in a report to clients.

OPEC members once drew their power from the giant reserves of what is known as “easy oil”—conventional crude that costs as little as $3 per barrel to pump. That cost guaranteed both fat profits when prices were high and the ability to hunker down when the market tanked.

Several years of $100 a barrel oil prices lasting until 2014 coincided with big military, security and domestic spending to pacify restive populations during the Arab Spring, hold back the tide of Islamic State and influence the Syrian civil war. Those spending obligations meant OPEC was fundamentally unprepared for the oil-price crash that followed.

The U.A.E. spends only $12 to pump a barrel of oil but needs oil to sell at $67 to cover its government expenditures, according to the International Monetary Fund. Its national budget has quadrupled to over $114 billion over the past 15 years.

The social spending helps regular Emiratis with housing costs, water bills and cheap electricity—subsidies that the U.A.E. government has been unwilling to significantly cut for fear of street protests.

The Persian Gulf country also has major military commitments, spending about $23 billion a year on defense—more than conflict-heavy countries like Israel and Iraq—as it helps fight wars in Syria and Yemen.

The U.A.E. is among OPEC’s worst offenders in pumping too much oil. It has cut only about half the amount it promised, according to the International Energy Agency, which advises governments and companies about energy trends.

A U.A.E. official said the country’s oil production is tied up in joint ventures with foreign oil companies that are hard to change, making it difficult to cut output. The country’s officials have said they plan to cut more oil production and recently announced limits on their oil exports.

In a move that could put pressure on the U.A.E., OPEC and Russia are planning a meeting of midlevel officials in Abu Dhabi on Aug. 7, the cartel said, “to assess how conformity levels can be improved.”

Overall, OPEC on Nov. 30 agreed to cut production by 1.2 million barrels a day, a deal that took almost a year to negotiate and raised expectations for an oil-market rally. Instead, member exports in June were 120,000 barrels a day lower than October, according to Kpler, a firm that tracks tanker movements to measure oil exports.

“OPEC will have lot of difficulties to respect its commitments because of budgetary difficulties faced by some its member countries,” said Chakib Khelil, the former oil minister of OPEC member Algeria.

Ecuador’s oil minister, Carlos Perez, went on state television this month to say the tiny producer was no longer sticking with its production pledges, “because of the needs that the country has.”

Iraq faces a budget squeeze from its war with Islamic State. It pledged to cut over 200,000 barrels a day but has cut less than half that amount on average through June, according to the IEA.

“Completely untrue and groundless,” Iraq’s Oil Minister Jabbar al-Luaiby said of the overproduction accusation. “Iraq is in full compliance with the OPEC declaration.”

In Saudi Arabia, which produces 30% of OPEC’s output, oil revenue has fallen 60% since the mid-2014 peak in oil prices. In that time period government spending declined only 18%, according to Goldman Sachs.

Instead of cutting spending, the Saudis have drawn down $246 billion of their foreign reserves and issued a $17 billion sovereign bond.

“We calculate, and a lot of people we know calculate, there’s about three more years of this they could deal with, with regard to drawdowns in the sovereign funds—and then they’ve got a very severe problem,” said Tim Dove, chief executive of Fort Worth-based Pioneer Natural Resources Co., a shale driller.

Saudi officials said they can withstand low prices for longer than any other country.

The Saudis haven’t dialed back increases in defense and infrastructure spending, including a $23 billion Riyadh metro system expected to be completed in 2019. Defense and security spending jumped 50% between 2010 and 2013, and defense spending grew again last year to $50 billion amid involvement in wars in Yemen and Syria.

The kingdom is working on plans for an IPO of part of its state-owned oil firm, Saudi Arabian Oil Co., known as Aramco. The listing, expected to be the largest-ever public offering, is expected to fetch tens of billions of dollars that Crown Prince Mohammed bin Salman has said he plans to put in a sovereign-wealth fund to invest in new industries, with the goal of reducing the country’s reliance on oil revenue.

The impending IPO was the impetus behind Saudi Arabia’s decisionlate last year to reverse itself and push OPEC to cut production and raise oil prices, according to people close to the kingdom’s oil ministry. The value of the IPO could depend in part of the price of oil, which the Saudis want to rise to $60 a barrel, the people said.

Mr. Falih denied the cuts are designed to lift prices for the IPO.

Saudi and other OPEC officials once believed U.S. shale producers needed oil prices of $80 a barrel or higher to function. The U.S. financial system and bankruptcy process helped ensure that oil fields continued to pump, even though more than 250 North American oil drillers and service companies have gone bust during the oil slump, according to Haynes and Boone, a law firm specializing in the energy industry.

The continued production helped pay down debt while companies reorganized. When the producers emerged from bankruptcy, new owners had the old debt load wiped clean. With a clean slate, plumbing once expensive shale fields became more economical. Other companies on the ropes sold to stronger rivals that can manage the fields more effectively or issued new shares to raise capital.

On Friday, big U.S. oil firms reported some of their strongest quarterly profits since the price crash.

There are signs that OPEC’s goal of reducing oil in storage, a proxy for the global oil glut, is slowly starting to happen. U.S. inventories have fallen in 14 of the past 16 weeks.

Lower imports into the U.S. have played a role, with Saudi Arabia intentionally lowering its shipments. Imports from Saudi Arabia to the U.S. are at a two-year low, down by about a third since January, data-tracking firm ClipperData said Friday.

Russia, the world’s largest crude producer but not an OPEC member, has gradually cut output by about 300,000 barrels a day since the agreement, the IEA said.

Oil prices have risen over 9% since last week’s meeting in St. Petersburg, when Saudi Arabia said it would go further than limiting its production by also placing a cap on its exports.

Officially, OPEC said the cartel as a whole is complying with its production-cut agreement, with output averaging more than one million barrels a day less this year compared with October 2016, helped by larger-than-agreed cuts by Saudi Arabia. “In all my long years in OPEC, I have not seen this high level of commitment,” said OPEC Secretary General Mohammad Barkindo.

But monthly figures show output recently has moved higher, according to observers including the IEA, which said seven of the 11 OPEC members that pledged to cut were producing more than promised.

OPEC has a long history of fractious relations among its members, a collection of regimes from the Middle East, Africa and South America.

Even the cartel’s most powerful moment, the 1973 oil embargo, divided the group, with only its Arab members taking part in cutting off crude to Western nations that supported Israel.

In 1986, Saudi Arabia was so upset about OPEC members flouting production agreements that unleashed a flood of oil that sank prices long-term, a period known as the “Lost Decade.”

When oil prices began falling in July 2014, then-Saudi oil minister Ali al-Naimi said OPEC no longer had the power—or will—to cut production and save the market. U.S. shale producers were too powerful.

But Mr. Naimi said he believed OPEC members’ still had essential advantages, such as the ability to produce at extremely low cost.

Mr. Naimi was replaced in May 2016 by Mr. Falih, a Western-educated oilman with long experience at Aramco. Mr. Falih has said Saudi Arabia and even OPEC couldn’t make a difference by cutting production on its own.

He reached out to Alexander Novak, energy minister in Russia, where low oil prices were creating a budget crunch for President Vladimir Putin just as he was escalating his country’s military support of Syrian President Bashar al-Assad.

“We both had an extended crisis,” Mr. Novak said in an interview. “We both wanted results.”

OPEC’s agreement last year with Russia and other big producers gave the cartel a coalition that controlled about 55% of global oil output, its earlier level of dominance. Knowing that OPEC members cheated on production pledges in the past, the cartel created a compliance committee to monitor production and scold members who pumped more.

In April, Mr. Falih was upset after reading a news article about Iraq pumping over its limit and stealing market share from Saudi Arabia. The kingdom had been cutting more than it pledged to make up for reported laggards like Iraq.

“See, they are laughing at us,” Mr. Falih wrote in a WhatsApp message to a group of peers, according to people familiar with the exchange.

In Iraq, there is a strong feeling that the country should be exempt from cutting production because of the war against Islamic State, said Luay al-Khatteeb, an adviser to the Iraqi parliament.

He pointed to an issue of lingering resentment in OPEC: “The Saudis are only cutting because they want better prices for the Aramco IPO,” he said, a notion Mr. Falih denied.

OPEC members said they are trying now to negotiate a way to quit the production cuts early next year without sending the market into another downturn.

Some are planning significant major new oil projects between now and 2020, Goldman Sachs said, including the Upper Zakum expansion in the U.A.E., which has the potential to add 1.1 million barrels a day to the market.

Saudi Arabia itself is ramping up expansions at its Khurais and Shaybah fields and is considering a new project at Manifa, which could boost output from that field by more than 60%, to 1.5 million barrels a day.


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