Saudia Arabia's U-Turn: Back tracking meets fracking?

By Nick Stamenkovic - 10th October 2016

Saudi Arabia has finally backed down from its high horse to seek a cut in OPEC oil output, the first in 8 years. Unless OPEC discipline miraculously improves, Saudi Arabia will need to make the most of the output sacrifice itself. November’s formal OPEC meeting will spill the beans on the output quotas.

In late 2014 Saudi Arabia stunned markets by refusing to cut oil output, signalling its determination to boost its market share. The message to the US shale gas industry was loud and clear: the recent ascendancy of the US as the world’s largest oil producer would no longer be tolerated and the US would pay for its aggressive policy stance. The subsequent collapse in oil prices prompted a severe shake-out in the US oil industry: the oil rig count plunged, production fell and defaults in the energy sector soared as highly leveraged companies suffered in the aftermath.

Saudi Arabia pretended that the weak oil price was painless. However, the prolonged and pronounced fall in energy prices from mid-2014 until early 2016 took its toll on the Saudi Arabian economy. Investment was slashed, the fiscal position worsened and capital outflows increased. The upshot was that the authorities were forced to provide liquidity for domestic banks to stave off a potential financial crisis and forced to raise funds on domestic capital markets to stem the pressure on diminishing FX reserves. Even social spending has been cut and subsidies reduced to prevent a further erosion of the government’s accounts, risking increased social tensions. This about-turn is fully justified.

Saudi Arabia is now a reluctant swing producer. The onus is on other OPEC members to step up to the plate and deliver output cuts, but will they? The trouble is that Iran has already threatened to raise output further following the end of US sanctions, raising tensions with Saudi Arabia. Venezuela is unlikely to provide much help given the dire state of its economy and its heavy dependency on oil. Nigeria and Libya, meanwhile, are suffering from production outages.

Little by little the oil market is tightening but the International Energy Agency (IEA) estimates oil market balance will not be fully restored until the second half of 2017, even if the current agreement sticks.

OPEC’s latest last ditch agreement signals Saudi Arabia’s attempt to drive US oil companies into the ground has failed. The pain endured by Saudi Arabia has proved too much to bear. The bottom in oil prices has been reached and a further rise would be welcome news for financially constrained US frackers.


 


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