Tug of War
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Donald Trump is pushing for oil prices to be kept as low as possible while pressuring oil producing countries, led by U.S. ally Saudi Arabia, to review the terms of the 2016 OPEC+ agreement and allow America's rising reserves access to the market

For oil markets and OPEC’s key policymakers, 2018 has been an unusual year. The success of the 2016 OPEC+ cuts agreement that saw a landmark deal between OPEC and several key non-OPEC oil producers to restrain output and stabilize oil prices at a higher level opened a new chapter in oil diplomacy. It proved that coordination across the OPEC/non-OPEC divide, especially between Saudi Arabia and Russia, was not only possible, but offered a sustainable new format for oil market management. Stronger than expected global oil demand growth and adherence to the cuts by OPEC+ in 2017 delivered a price recovery that saw Brent prices average over USD 54 in 2017 and extend to highs above USD 80 in Q4 2018. But if OPEC worked hard to create a new framework for supply management, a new oil price driver was about to enter the stage. President Trump’s decision to pull out of the Iran nuclear agreement and reimpose sanctions on Iranian oil exports was not unexpected. But a lack of detail about the policy created fresh uncertainty on supply, helping to sustain a geopolitical risk premium that saw prices crest well above USD 80 in the autumn. Yet it was Trump’s controversial public criticisms of OPEC and its actions and his regular commentary on the oil price, delivered publicly by tweet, that created the highest level of confusion among OPEC producers and within the oil market itself. Trump seems to have the capacity to pull the oil market in sharply different directions.

The 2016 deal–a historic success

These developments came after a period of historic success for the producer group. In early 2018, there was no enthusiasm for abandoning the cuts prematurely. Despite evidence that oil stocks had moved below the five-year average, the hunt was on to establish new benchmarks that would justify cuts being left in place. OPEC’s assessment in late 2017 was that the cuts, which had delivered record compliance levels above 100 percent on the back of both disciplined supply restraint and unplanned outages and declines across several member countries, should extend through the whole of 2018. This analysis was underpinned by the view that it took a lot of time and effort to seal the 2016 output cut agreement and it would be safer to overtighten the oil market than risk a return to the oversupply situation that created record stock builds from 2014 to 2016 and sent oil prices to historic lows below USD 40.

Early in 2018, the demand picture looked particularly strong, and while the U.S. supply was growing strongly, there was no sign at that point of the extent to which North American growth estimates would have to be upgraded. In March, the view according to OPEC’s monthly oil market report was that the call on OPEC crude would be 32.6mn b/d in the year, with demand growth at 1.6mn b/d and non-OPEC supply growing by 1.66mn b/d, of which the the U.S. alone was expected to contribute 1.46mn b/d.

But by the end of the year, some of those forecasts had been sharply amended to account for much stronger U.S. liquids supply growth and downgraded demand growth due to concerns about the prospects for the global economy on the back of the U.S-China trade war, a deterioration in the outlook for some emerging economies, and the impact of the higher oil prices on demand. While the November report held the 2018 call on OPEC crude unchanged at 32.6mn b/d (the forecast for 2019 was lower at 31.5mn b/d), the non-OPEC supply growth forecast for the year had been lifted by a total 650,000 b/d, mainly on the back of a 600,000 b/d upgrade to U.S. liquids growth, which now stands at 2.06mn b/d. Russian supply had been upgraded to annual growth of 70,000 b/d from an earlier forecast for a decline of 160,000 b/d. That level of non-OPEC supply growth is forecast to be mostly sustained in 2019, according to OPEC’s own forecasts, at 2.23mn b/d, creating a sharply lower demand for OPEC crude.

OPEC+ reinvents oil diplomacy

But if the market balancing mission looked tough, the policy infrastructure appeared capable of handling the challenge. The 2016 OPEC+ cuts deal was significant beyond its impact on physical oil balances. It sent a strong message to markets that major producers had reinvented oil diplomacy in a new image—a structure that delivered market credibility and in which longtime OPEC heavyweight Saudi Arabia was able to be influential, to the point where it had persuaded Russia to join it. Not only did this multilateral element send a strong message, but the consistency and commitment with which Riyadh was prepared to pursue its market aims was underlined by its readiness not to exit the deal prematurely.

Yet Riyadh’s efforts to maintain output targets were to be derailed by two important developments. President Trump’s impact on oil markets occurred in two ways.

First, he announced the U.S. withdrawal from the JCPOA, the nuclear deal that had lifted sanctions on Iranian oil exports and freed up Tehran’s access to global financial markets, banking and investment in return for restrictions on its nuclear program. The decision, announced in early May, was by that point expected, Trump having made it clear in late 2017 that he would no longer agree to certify Iran’s compliance with the deal. On the face of it, the move supported the OPEC+ mission of tightening supply, implying the loss of Iranian exports over time, a shift that would contribute significantly to the bullish market narrative that dominated from this point until early October.

U.S. officials let it be known that their approach to Iran sanctions would be draconian and zero-sum compared to the approach adopted by President Obama. The White House declared it wanted to see Iranian oil exports reduced to zero, an attempt to strangle the Iranian economy, correct Iran’s regional behavior and even bring about regime change, according to senior administration figures.

Saudi Arabia played a significant role here, assuring the U.S. it would make up for any supply shortfall created by the loss of Iranian barrels. The possibility that Iran oil exports would be completely choked off, with a resulting loss of some 2.4mn b/d, upheld the bullishness of oil markets through the summer, bullishness inspired by the belief that the November re-imposition of sanctions on Iran by the U.S. would result in a precipitous collapse in Middle East oil supply. Many market players doubted whether OPEC spare capacity was sufficient to make up for losses of that size.

Russia, as Saudi Arabia’s key non-OPEC partner in the 2016 cuts deal, also made OPEC and Saudi oil diplomacy more complicated from June onwards, making clear that while it was prepared to nominally remain within the cuts framework, it would no longer restrain supply growth. Effectively this was an exit from the deal after the May presidential elections that had returned President Putin for a fresh term in office. Moscow was certainly content to soft-pedal its weakening adherence, speaking in supportive terms but essentially allowing companies to implement their delayed growth plans. Given Moscow’s readiness to underline its readiness to maintain cooperation, this was less of a challenge than President Trump’s attacks on OPEC.

Trump's litany of complaints

President Trump launched his first Twitter salvo against OPEC in April, accusing the group of keeping oil prices “artificially high” despite abundant oil supplies. The tweet, published just as OPEC officials and ministers were meeting in Jeddah, was a hammer blow to the organization. Certainly U.S. feedback on OPEC policy was nothing new, but the blunt, undiplomatic and public way it was delivered took OPEC officials by surprise. And it was just a start, as Trump continued to launch a barrage of complaints against OPEC over the subsequent months, deriding the organization in campaign speeches ahead of the U.S. midterm elections.

The attacks did not seem to be purely rhetorical, and OPEC officials feared there was substance and the possibility that U.S. legislators would carry forward the draft NOPEC bill, which sought to allow OPEC countries to lose sovereign immunity from potential prosecution under U.S. antitrust law. The NOPEC bill has seen several incarnations since 2008 and, given its rare bipartisan support in Congress, is seen by OPEC officials as a genuine threat to the organization.

President Trump’s call for OPEC to maintain a higher oil supply and bring prices lower was a key challenge to OPEC’s efforts to establish a credible market management message ahead of the June OPEC meeting. Not only did Saudi Arabia have to contend with the de facto departure of Russia from the cuts, but it had to appear receptive to the U.S. message increasing supplies to keep a cap on the oil price, while at the same time working to prevent an uncontrolled slide in oil prices. This then became the genesis of the conflicted Saudi policy that has resulted in a few U-turns and made credible market messaging so much more difficult in the run-up to the 2018 December OPEC meeting. Aside from the U.S. pressure to send oil prices lower, even after declining by more than 30 percent since the early October peaks, the U.S. announcement of widespread waivers on Iranian oil sanctions took the market and OPEC oil producers by surprise. The absence of any coordination on this volte-face in U.S. policy took Saudi Arabia by surprise, as it had already opened its taps to reassure markets and accommodate the U.S. Iran policy and was now faced with a bearish oil market that would require it to rein in the surge. In November 2018, Saudi output exceeded 11 mb/d, 1 mb/d above its OPEC quota. Even in the face of the recent price fall, Trump continues to urge Saudi Arabia not to change course and cut output, congratulating himself for providing American citizens, but also other net oil importers, with a “tax cut.”

Saudi choices are getting harder and harder

Intervention from the White House has left Saudi Arabia facing multiple new challenges, many of which emanate from the U.S. A constant challenge for OPEC has been to identify the nature of the shock hitting the market. If the declines in the oil price are temporary, driven for instance by speculative demand pressures and by deterioration in expectations, then Saudi Arabia’s push to cut output to stabilize market expectations and reverse the oil price decline could result in higher and more persistent price gains. On the other hand, if the declines in oil price are driven by structural shifts in supply-demand, then Saudi Arabia may be reluctant to cut oil output as this would result in reduction in market share and revenues, as any temporary gains in the oil price will fade. So how Saudi Arabia perceives the shock is one of the key determinants of its output decision. The rapid growth in U.S. shale supply and the resulting shift in trade flows, its short-term investment cycle, and its responsiveness to price signals represent new structural features in the oil market, features which complicate OPEC’s management of the oil market. Another structural change is the increased uncertainty in the prospects of global oil demand growth as governments pursue more aggressive climate change and air pollution policies and as technological advancements are expected to reduce the share of oil in the transport sector.

However, the U.S. impact on the oil market is not only confined to developments in U.S. shale. President Trump’s capacity to influence and even take credit for oil market moves remains undimmed. This has created a conflict for Saudi Arabia. On the one hand, the Kingdom needs oil prices to regain upward momentum in order to meet its revenue targets and continue its spending on welfare and the reform agenda that is crucial to the country’s long-term economic well-being. Unlike in 2014, when Saudi Arabia decided not to cut output in face of a structural shock to market fundamentals (slowdown in demand growth, rise in U.S. shale production, and the return of many disrupted countries to the market), the Kingdom’s current financial buffers are thinner and the prospects for its economy and the private sector are weaker, while government spending keeps rising. At the same time, Riyadh can’t be seen to be pushing oil prices to high levels, and at a minimum not be seen as a leading voice for sharp output cuts. This represents a fundamental shift in market perceptions about Saudi oil policy as the market doubts that Saudi Arabia can make its output decisions independent of pressure from Trump. These constraints may require the Kingdom to change how it acts and signals to oil markets.

The future conditions

Looking ahead, two factors will remain uppermost: U.S. policy on Iran and President Trump’s capacity to preserve the strategic relationship with Saudi Arabia amid pressure for some form of sanctions from Congress. On the former, the U.S. focus on countering Iran’s influence in the region appears to be undimmed, even if the tactical pathway has become confused due to the sanctions waivers. On the latter, President Trump is keen to preserve its strategic relations with Saudi Arabia and has little enthusiasm for putting arms sales to Saudi Arabia on the table for discussion. As such, one should assume that core strategic relations between the U.S. and Saudi Arabia remain cemented in place, even if the bilateral relations have suffered in the wake of the Khashoggi affair. Saudi Arabia itself will need to continue to perform a delicate balancing act. It must keep oil prices moderate enough to avoid censure from the White House, avoid slowing down demand growth, and moderate U.S. shale supply growth, but also put in place long-term policies that secure the kingdom’s finances. Until real economic reform and economic diversification is enacted, Riyadh cannot afford to abandon its short-term market-balancing efforts, efforts which will become increasingly difficult.

 


Bill Farren-Price and Bassam Fattouh

Bill Farren-Price, Director of RS Energy Group, is an experienced analyst and researcher with a focus on MENA region energy and politics.

Bassam Fattouh is the Director of the Oxford Institute for Energy Studies and Professor at SOAS (School of Oriental and African  Studies), University of London.