OPEC production cut: Just another Saudi head fake?

What do you do when everyone is bugging you to do something, but you don't want to do it? The simple answer is that you make it look like you are doing something in order to get others off your back.

It is not always easy to tell what people's intentions are. But we can look at what they have done in the past. The main thing that the Kingdom of Saudi Arabia has done over the past year in response to pressure from other OPEC members is talk about steps it would take to raise oil prices. But in the end the kingdom doesn't actually do them, or it does things which have no practical significance. (Saudi Arabia, the world's largest exporter, is the OPEC member with the greatest flexibility in its production. Any OPEC production cut without Saudi leadership would lack credibility.)

We should keep all this in mind when evaluating the latest reports that OPEC has agreed to cuts. Bloomberg tells us right up front that OPEC has merely agreed to the "outline of a deal" that will be taken up at its November meeting.

One of Saudi Arabia's partners in its yearlong public talkfest has been Russia, the number one or number two oil producer in the world depending on what month it is. The Russians said in early October 2015 that they were ready to discuss oil prices with OPEC. Later that month it was leaked that the Russians had no intention of cutting their own production. In late January of this year, the oil price catapulted after Russia's energy minister said he was "ready to meet with OPEC and Saudi Arabia to discuss a production cut," the Financial Times reported.

When the Russians did meet with Saudi Arabia and also with representatives from Qatar and Venezuela in late February, the group proposed a freeze in production, but no production cut. Only the uninitiated may be forgiven for not understanding that a freeze would change nothing. Oil production would simply continue at the current level, hardly a strategy to achieve higher prices.

In early March the Russians announced that their oil companies agreed to a freeze in production. In late March the Saudis announced that they, too, would be freezing production even if Iran would not commit to a similar freeze. The Iranians, of course, have been keen to get back into the export market in a major way after having been crippled by trade sanctions for years, sanctions which have been lifted in the wake of an international agreement governing Iran's nuclear program.

The stated intention of the Saudis and the Russians was to raise oil prices. But, given that the practical effect on production was zero, they must have had some other method in mind. One possibility is that they have been working together simply to jawbone the price of oil higher without having to reduce production. If that's the case, it seems to have worked reasonably well as all the announcements of meetings and rumors about what might happen at those meetings seem to have coincided roughly with a rising price.

It's also possible that the Saudi-Russian tag team has been trying to kill two birds with one stone. These producers might also have been seeking to keep market participants guessing about the future of prices so as to dampen investment in U.S. shale-based operations, operations which have helped to create an excess of oil on the market. Uncertainty breeds fear, and fear keeps investors away. By making periodic announcements about cuts and freezes followed by rumors or statements that undermine the original announcements, they are creating the requisite uncertainty.

In April OPEC and other producers discussed a freeze, and then the very next day failed to implement one. In mid-August, the Saudi oil minister was quoted as saying that OPEC members would consider "any possible action" at a meeting the following month. This rather mild statement was followed by a 4 percent rise in crude prices.

The record of Saudi announcements and actions suggests they are not serious. In fact, shortly after the recent announcement that OPEC would be cutting production, Saudi Arabia lowered prices for its crude, a move not consistent with its stated aims. The OPEC agreement to cut production, the first in eight years, may not actually deliver any results given that Iran is exempt, that a production range was adopted, and that OPEC members routinely cheat on quotas.

But, of course, the Saudis know all this. The question is whether they care. It turns out that the Saudis have not finished the job they set out to do, a job which few commentators have properly understood. The kingdom has been seeking not merely to lower the production of oil from U.S. shale deposits--a goal which they've already achieved--but also to cripple funding for new projects.

As oil hovers around $50 per barrel, investors continue to plow additional funds into shale drilling, particularly the Permian Basin in Texas. There may indeed be wells there that will be profitable at this level, but not an unlimited number. Other shale areas such as North Dakota have seen drilling activity slow to crawl.

What the Saudis want is for investment money to dry up. In order for that to happen investors in U.S. shale have to feel more pain--so much pain, in fact, that they won't be eager to jump in again even as prices rise.

That's why I don't believe the announced oil production cuts will ultimately have any noticeable effect on production--because I think the Saudis don't want them to. While some commentators contend that Saudi Arabia is surrendering in its war on shale, I believe the kingdom is merely giving everyone another head fake just as they and the Russians (and now the Algerians) have been doing all year.

They got a 5 percent bump in the oil price on the day of the recent production cut announcement and total of about 11.5 percent through Friday, October 7--all without actually cutting production by one barrel.* Now, that's a pretty effective head fake. What I can't figure out is why more people aren't on to this.

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*The mechanism that explains this is that speculators and users tend to increase inventories ahead of anticipated price hikes, thus temporarily increasing demand for both physical and paper crude. That anticipation becomes a self-fulfilling prophesy as various actors in the market rush in together to add to their physical or paper positions.

Kurt Cobb is an author, speaker, and columnist focusing on energy and the environment. He is a regular contributor to the Energy Voices section of The Christian Science Monitor and author of the peak-oil-themed novel Prelude. In addition, he has written columns for the Paris-based science news site Scitizen, and his work has been featured on Energy Bulletin (now Resilience.org), The Oil Drum, OilPrice.com, Econ Matters, Peak Oil Review, 321energy, Common Dreams, Le Monde Diplomatique and many other sites. He maintains a blog called Resource Insights and can be contacted at kurtcobb2001@yahoo.com.