Saudi tactics and the oil market energy focus

Oil Minister Ali Al Naimi refused to concede that the shale oil production in the US, the world’s largest energy consumer, was a strategic threat to the kingdom. He also ignored Iran’s pledge to raise output to four MBD even if prices fall by $20. The Saudis have the lowest production costs, highest spare capacity and are producing 10 MBD of the benchmark Arabian Light crude. The Saudi kingdom alone has the power to act as the Opec’s swing producer, to punish quota violators by causing oil prices to crash (a strategy Shaikh Zaki Yamani used to punish Nigerian quota cheating and respond to Britain’s North Sea offshore oilfields in the 1980s).

However, Al Naimi does not have the luxury of strategic options enjoyed by his predecessors. Saudi Arabia’s domestic consumption needs have soared as its 28-million population enjoys heavily-subsidised petrol and power while its oldest oilfields, notably Ghawar in the Eastern Province, the largest single oilfield in the history of the hydrocarbon age, is in clear production decline. So even though other Opec producers are “cheating” by 900,000 barrels a day above the official Opec quota, Saudi Arabia can do nothing to restrain them, even in the face of softer Chinese demand, a collapse in jet fuel prices and a glut of Nigerian, Angolan and Iraqi crude oil on the spot market. Saudi Arabia’s break-even budget price is now $90.

The kingdom is engaged in geopolitical conflicts that range from Yemen to Syria/ Iraq and Lebanon in the Arab world. “Riyal politik” is the kingdom’s traditional currency of power. In any case, Saudi Arabia responded to the Arab Spring with $138 billion in social welfare spending. The “Yamani option” is no longer available to Saudi Arabia. The Opec’s own economists estimate that demand for its member’s crude will fall by 400,000 barrels a day. This means oil prices will fall unless Saudi Arabia unilaterally cuts its output, as it did in 2008 to engineer the biggest output cutback in Opec history after Brent crude fell below $100 during the global banking crisis.

Saudi Arabia’s greatest near-term challenge is not US shale oil but the exponential rise in Iraqi oil production since the overthrow of the Saddam regime. The IEA estimates that the Opec’s production capacity could rise to 36 MBD, thanks to Iraq’s re-emergence as a major global oil exporter after decades of war, terrorist sabotage and UN sanctions. Iraq is already the Opec’s second-largest oil exporter after Saudi Arabia. Baghdad is also a de facto ally of Iran. Will Saudi Arabia willingly cut its oil output by 2.5 MBd to accommodate Iraq? Of course not. As offshore oilfields are discovered in West Africa, Norway, Russia, Brazil and the Gulf of Mexico, the prospect of an oil glut and a crash in oil prices can only increase.

Saudi Arabia, Qatar, the UAE and Kuwait have publically declared their satisfaction with $100 Brent oil prices. However, Gulf Arab exporters will not be able to stabilise the world oil market if Iraq insists on its “sovereign right” to ignore Opec quotas and maximise its oil output. This means Iraq could well decide to leave the Opec. This decision means another million barrels of Kirkuk/Basra crude and a major oil price fall, particularly if Libyan exports resume.

Saudi Arabia will not cut its oil production below nine MBD because the kingdom subsidies electricity usage and gasoline for its citizens, the constraints the national security/defence budgets, subsidies to Petromin and Sabic and the post-Arab Spring surge in social welfare. This was not a problem as long as supply shocks existed in Iraq, Nigeria, Libya, Sudan, Syria and Yemen. However, the US-Iran nuclear deal in Geneva has introduced a new variable in the oil market. Iran expects to produce an extra one MBD once US/EU banking, shipping and insurance are eased. Iran, with 35 per cent unemployment and 50 per cent inflation, is desperate for foreign exchange.

Economics, not ideology, compelled Supreme Leader Khameini, the Majlis and the Revolutionary Gurads to accept the Kerry-Zarif deal in Geneva. Iran is negotiating with Total, Statoil, ENI and Shell for contracts to develop its oil and gasfields near the southwest border with Iraq. Iran will ignore any Opec output cut in its quest to maximise production and hard currency earnings. Iran was once the Opec’s second-largest producer under the Shah’s regime. The Saudi-Iran rift will unsettle world oil markets.

The writer is a Dubai-based research analyst in energy and GCC economics.