Saudi can raise oil prices without losing market share.
The Organisation of the Petroleum Exporting Countries surprised oil traders and analysts by announcing a production deal following a hastily convened extraordinary meeting in Algiers.
The Algiers agreement seems to have been designed to engineer an increase in prices by changing market sentiment rather than reducing the physical supply of crude.
Opec issued a statement of just under 700 words following the meeting. The operative parts, which consisted of two paragraphs or 105 words, recorded two decisions:
(1) Opec's 14 members committed themselves to a collective production target ranging between 32.5 million and 33.0 million barrels per day.
(2) A high-level committee will be established to study and recommend the implementation of the production level by individual member countries and consult with non-Opec oil producing countries.
The production target was the first time that Opec members had committed themselves to an overall output level since June 2015.
But the critical question is whether the production target will affect the actual number of barrels being marketed by the organisation's members.
Should the collective production target be characterised as a cutback, a freeze or continued, albeit restrained, growth?
The answer depends on the baseline against which the target is measured and what would have happened in the absence of a deal.
Opec members produced an average of 33.24 million barrels per day in August, according to estimates by secondary sources published in the organisation's own monthly oil market report.
If the production target is compared with the production level in August, then it represents a cut of somewhere between 250,000 and 750,000 barrels per day.
But Opec members, led by Saudi Arabia, boosted their production during the summer, in part to meet strong domestic demand for power generation.
Saudi Arabia's own oil production showed a seasonal increase of around 400,000 barrels per day between May and August.
In most years, Saudi Arabia's output has been reduced once the summer heat is over and the need for direct crude combustion in power plants falls. Before the summer, Opec members were producing around 32.25 million barrels per day, with an extra 200,000 barrels per day being produced by Gabon, which rejoined Opec on July 1.
If the production target is compared with pre-summer Opec+Gabon output of 32.5 million barrels per day, it represents a production freeze compared with the first half of 2016 or even a slight increase.
So the fairest way to characterise the output deal is probably as a production freeze, rather than a production cut.
SAUDI SHOWS FLEXIBILITY
Following the agreement, Saudi Arabia will reduce its crude production after the summer, which it would probably have done in any event, based on past behaviour.
But the target creates some limited flexibility for Iran, Libya, Nigeria, which claim their production has been temporarily disrupted, to pump more in the months ahead.
The output deal will therefore not actually remove any barrels of oil from the market in the remainder of 2016 and 2017.
Some Opec members are already disputing the details. The collective target does not include individual country allocations.
Iraq has said its output is being under-estimated by the secondary sources and it will not be bound by the ceiling unless its baseline is revised.
But Opec is hoping that continued growth in oil demand coupled with an output freeze will create a deficit and start drawing down the excess stocks that have accumulated since 2014.
The deal represents a significant shift by Saudi Arabia which had previously insisted it would only agree to a freeze if it was joined by all Opec and major non-Opec producers.
Saudi Arabia has now said other Opec members, including arch-rival Iran, will be free to produce "at maximum levels that make sense". Non-Opec producers, including Russia, are not formally associated with the freeze.
In that respect, Saudi Arabia seems to have gone to Algiers determined to announce an agreement, and willing to show whatever flexibility was needed to obtain one.
STRATEGY WAS NOT WORKING
The kingdom's change of heart seems to have come from a realisation that low oil prices were not rebalancing the market in the way that official hoped.
Since 2014, Saudi policy has aimed at protecting its share of the crude market while allowing prices to find their own level.
Lower prices were expected to curb production by other producers with higher costs while improving the kingdom's long-term position.
However, while shale production in the United States has been falling since early 2015, it has been more than offset by increasing output from Opec members.
Oil consumption has grown rapidly but not fast enough to soak up all the extra oil being supplied and start drawing down stockpiles in a meaningful way.
The kingdom's strategy assumed it had sufficient financial resources to withstand a prolonged period of low prices while competitors would be forced to scale back.
But the downturn in oil prices has lasted much longer than Saudi policymakers thought likely in 2014 and shows no sign of ending.
Falling oil revenues have pushed the kingdom's economy close to or into recession and are requiring deep cuts in government spending on infrastructure as well as social payments and salaries.
Saudi Arabia's foreign reserves have declined by $182 billion, 24 per cent, since August 2014.
Reserves declined by $53 billion in the first seven months of 2016, despite big cuts in government spending and attempts to raise non-oil revenues.
The kingdom still has reserve assets valued at $564 billion and substantial ability to raise more money by issuing debt.
But it also needs to preserve a large reserve cushion to maintain confidence in the riyal's peg to the US dollar, limit capital flight and avert a run on the currency.
The kingdom's production policy was ultimately on an unsustainable financial course, so policymakers, under a new oil minister, have modified it.
The decision almost certainly includes a strategy shift at the top of the Saudi administration, where Deputy Crown Prince Mohammed bin Salman has emerged as the key decision-maker.
MODEST PRICE BOOST
Prince Mohammed indicated earlier this year it did no matter for the kingdom whether oil prices were $30 or $70 per barrel. But in recent months officials have indicated they believe prices are unsustainably low and want them to rise.
The agreement was meant to signal a new Saudi willingness to temper its production even if other members of the organisation manage to increase their output marginally.
The Saudi calculation seems to be that the kingdom will gain more from an increase in prices than it will from any reduction in the number of barrels sold.
In any event, Saudi policymakers probably calculate, correctly, that rival producers have little capacity to raise output in the short term.
Iran is close to its pre-sanctions production capacity and will need significant investment to achieve substantial increases in output. Russia, too, probably has limited ability to increase production in the short term.
Libya is likely to remain a failed state. Nigeria is struggling to re-establish security in its oil-producing areas. And Venezuela remains in the throes of a prolonged internal political and economic crisis.
Saudi Arabia is unlikely to lose much market share to other members of Opec if it limits its own production to the level achieved in the first half of 2016.
Limiting its own production could accelerate the oil market rebalancing process while leaving Saudi Arabia free to increase output later once stocks have started to come down.
The main threat comes a potential increase in shale production in the meantime. US shale companies have already added more than 100 drilling rigs since the end of May but the sector remains under intense financial pressure.
The Saudis probably calculate that an increase in prices to $50-60 per barrel would bring useful extra revenue without stimulating too much extra shale production.
The Algiers agreement is a gamble that Saudi Arabia can achieve a modest boost in prices and revenues by freezing output, talking up the market and accelerating the rebalancing process, without losing too much market share.
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