Don’t get your hopes up that the oil market’s headed back to the future.
Ever since OPEC output quotas were introduced in the 1980s, Saudi Arabia has been the group’s great leveler, making more than its share of production cuts when prices needed support, while remaining the only member with enough spare capacity to raise production in times of shortage.
That all changed in 2014. In November that year, oil minister Ali Al-Naimi said the Saudis would no longer cut output to support prices and subsidize high-cost rivals. His successor, Khalid al-Falih, only agreed last year to return to actively managing supply provided production cuts were collective and the burden was shared equitably.
Early evidence of actual cuts seems to show that the kingdom has resumed its old swing producer role, doing more than its share to cut output in the hope of rebalancing the oil market. But there’s more to it than that.
Data published on Friday by the International Energy Agency show Saudi Arabia reduced its output in January by more than required under the November 2016 agreement. A cut of 560,000 barrels a day from the October baseline level was 14 percent more than the kingdom’s pledged reduction of 490,000 barrels. That certainly looks like the behavior of a swing producer.
So how should we read that bigger-than-required output cut? It may be tempting to see it as a move by the kingdom to offset rising output from Libya and, to a lesser extent, Nigeria — both of whom were exempt from cuts under the November deal. But I see it as a further indication that this may be as good as it gets for compliance with the deal — a suggestion I raised last week.
When challenged on less-than-total compliance with previous output deals previous Saudi oil ministers invariably responded that it was the kingdom’s average production level over the duration of an output deal that should be considered, not its compliance on a month-to-month basis. If this is their argument this time around — and I see no reason to expect anything different — then Saudi production should rise in the coming months.
From one perspective, this should come as little surprise. The kingdom derives its oil income from exports of the black stuff, not from domestic consumption, which is still heavily subsidized. The logical desire for Saudi Arabia is to cut its output with minimal impact on its exports. It can do this by concentrating the output cut in the period — right about now — when its domestic oil demand is lowest.
Oil use in the kingdom is highly seasonal, peaking in the hot summer months when soaring demand for electricity to run air conditioners has required as much as 900,000 barrels of crude to be burnt in power stations. The increase in demand usually begins in April or May, although last year it was as early as March.
To avoid making significant cuts to high-value oil exports in order to meet loss-making domestic demand, Saudi Arabia will need to boost output as consumption at home rises. Reducing output more than it needs to now gives it the flexibility to do just that, while still abiding by its commitment on an average basis over the six-month life of the deal.
Front-loading the cuts also gives an early impression that the kingdom, and OPEC collectively, are serious about rebalancing the market. And this is working. Crude oil prices jumped by around 80 cents a barrel immediately after the publication of the IEA data — the biggest price response to the publication that I can remember in more than 25 years of studying the oil market.
At 90 percent, it looks like January may be as good as it gets for compliance. We may have another month or so before Saudi Arabia needs to choose between cutting exports or boosting supply, but it is difficult to see overall adherence getting much better without involuntary cuts somewhere due to accident or unrest.
