April 2019

Helima Croft: Oil price rally presents a tricky predicament for Opec (Financial Times Op-Ed)

The producers’ cartel is unlikely to back away from its strategy of production cuts

With oil prices up by almost one-third since the start of the year, questions are once again arising over when Opec will be able to declare victory and refocus on securing market share by restoring production. After all, for many publicly traded energy companies, a price of about $60 a barrel is enough to generate decent returns, given that they used the oil collapse of 2014-15 as a catalyst to rationalise spending, cut waste and improve efficiency.

But oil is now trading at more than $70 a barrel, prompting market participants to wonder why Opec is providing its rivals with a valuable financial lifeline.

Opec’s oil ministers say high prices are necessary to ensure that enough investment flows into the sector to stave off a potentially serious supply gap. Yet, we think that the uneven performance of Opec’s sovereign producers in using the price collapse as an impetus to push forward with urgently needed domestic economic reforms, also helps to explain their continued reliance on production cuts to shore up prices.

Oil prices remain below the fiscal break-evens for the majority of Opec, and with a production-weighted average fiscal break-even level of $91 a barrel, current prices still simply do not work for most of the producer organisations.

Moreover, as the recent events in Algeria demonstrate, a failure to satisfy the demands of their citizens — who represent the real shareholders of most national oil companies — still represents a potentially serious threat to the leaders of these hydrocarbon states.

Back in 2015, we began to gauge the resiliency of individual Opec member states across a “spectrum of pain”, assessing their ability to endure prolonged low oil prices. At one end were the Gulf states with flush sovereign wealth funds and small populations. We deemed these countries, such as the United Arab Emirates and Kuwait, as having the strongest shock absorbers to endure low prices.

At the other end of the spectrum were the “fragile five” — Libya, Nigeria, Iraq, Algeria and Venezuela. These countries were experiencing serious security, economic and political problems even when oil was at $100 a barrel and faced potentially ruinous outlooks when prices plunged.

Sitting in the middle was Opec’s largest producer, Saudi Arabia, far better off than the likes of Libya and Iraq with its large foreign exchange reserves and ample ability to borrow. But its large population meant that its oil money did not go as far as in smaller Gulf monarchies. Similarly, Saudi Arabia had substantial spending commitments that seemingly underpinned social stability. Hence, even with its remarkably rich resource endowment, the kingdom did not appear to have unlimited runway unless it was able to refashion its social contract and reduce its reliance on oil revenues.

Since then, the countries that were arguably best positioned to endure low oil prices have most effectively used the downturn in oil to push ahead with needed reforms. Meanwhile, those that were most vulnerable have essentially gone into survival mode, waiting for a recovery in prices to bail them out.

The UAE, which has the lowest Opec budget break-even of $61 a barrel in our rankings, has been one of the more successful sovereign producers in using the price decline to accelerate reforms that were already in the works. At the other end are several of the original fragile five. Venezuela, for example, faces the most catastrophic economic outlook, with inflation predicted to reach 10m per cent and gross domestic product contracting sharply again this year amid an ongoing economic and humanitarian crisis.

Saudi Arabia launched its sweeping “Vision 2030” initiative to much fanfare and has scored some important successes, including the scaling back of fuel subsidies and the introduction of VAT and excise taxes. There has also been a concurrent relaxation of some social restrictions and a provision of some new entertainment opportunities.

However, the country still has substantial state spending commitments and a high fiscal break-even of $88 a barrel in our analysis. In addition, more work needs to be done on reaching the goal of creating 1.2m new jobs by 2022 and increasing the private sector’s contribution to GDP from 40 per cent to 65 per cent, as laid out in Vision 2030.

At its heart, Vision 2030 seems to be grappling with the difficult truth that the country cannot rely on elevated oil prices in perpetuity. Some have suggested that Opec’s production cut provides a “bridge price” of sorts — a price level that enables the government to continue with the most critical reforms while still having the breathing room to fund the more popular social programmes that help keep the public placated.

Therefore, the duration of this bridge price for Opec and its current production policy may ultimately be linked to the success of national reform programmes within Opec, and particularly Saudi Arabia’s Vision 2030. Given the high stakes, these countries should take advantage of the current price environment to double down on reform efforts to prepare themselves for the coming energy transition. In that respect, they should take a page from the playbook of their publicly-traded peers.

Helima Croft is Global Head of Commodity Strategy at RBC Capital Markets in New York. This op-ed originally appeared in the Financial Times.