December 1, 2016

TSG IntelBrief: OPEC Finalizes a Cut in Oil Production

• On November 30, OPEC finalized the details of a tentative agreement made in September to reduce oil production, overcoming wide disputes between its biggest producers.

• The pact was facilitated by an agreement from the largest non-OPEC oil producer, Russia, to reduce production in concert with OPEC in order to raise world oil prices.

• The agreement represents an acknowledgment by Saudi Arabia that its strategy of trying to cripple the U.S. ‘fracking’ industry through low oil prices has failed.

• Four OPEC members—Iran, Iraq, Libya, and Nigeria—which are all involved in regional conflicts or the subject of international sanctions, will either be exempt from cuts or required to cut production only modestly.

A meeting of the Organization of Petroleum Exporting Countries (OPEC) in Vienna on November 30 decided that the organization would reduce its total crude oil production by about 1.2 million barrels per day (mbd), to about 32.5 mbd. The bulk of the OPEC production cut will be borne by the organization’s largest producer, Saudi Arabia, which will cut production by about 500,000 barrels per day. The agreement is in line with the tentative OPEC pact reached in September, including the stipulation that the new production levels of each OPEC member be specified. The agreement came together after Russia—the largest non-OPEC oil producer—separately accepted a production cut of 300,000 barrels per day. OPEC announced that its members would meet with non-OPEC producers on December 9 in Doha, Qatar to persuade all the non-OPEC producers, including Russia, to collectively remove 600,000 barrels per day from the market. Together, the OPEC and non-OPEC cuts are expected to sustainably raise world oil prices above $50 per barrel—assuming all parties to the agreements keep their commitments. The U.S. has become one of the world’s largest oil producers on the strength of the shale oil—or ‘fracking’—industry. The U.S. energy sector is private, however, and the U.S. has never been party to any OPEC or non-OPEC production agreements.  

Paving the way for the November 30 agreement was flexibility on the part of OPEC’s feuding members. With the Iran multilateral nuclear deal nearing one year of full implementation, Iran is emerging from five years of crippling economic sanctions. In the past several meetings, Iran—Saudi Arabia’s main regional rival—had steadfastly insisted that it be allowed to increase production to ‘pre-sanctions levels’ of about 4 mbd. Having nearly reached that level by October 2016, Iran entered the November 30 meeting opposed to a Saudi demand to reduce production to 3.7 mbd. In the end, OPEC agreed to allow Iran to roughly maintain current production levels. Iraq, which had also argued that it be allowed to increase production to fund its fight against the so-called Islamic State, agreed to a modest cut of 200,000 barrels per day. Saudi Arabia agreed to exempt Libya from production cuts on the grounds that the country needs funds to try to unify its post-Qadhafi political structure and combat an Islamic State affiliate there. Also exempted from cuts was Nigeria, which is fighting the Islamic State-affiliated terror group Boko Haram. 

The OPEC agreement reflects an acknowledgment by Saudi Arabia that its strategy since 2014 has failed. Saudi officials calculated that lower oil prices would crush the world’s biggest source of new oil production—the shale oil industry of the U.S. Saudi Arabia bet that large Saudi financial reserves would enable the Kingdom to ‘outlast’ the U.S. shale oil producers. In practice, however, low oil prices caused economic difficulties for Saudi Arabia and its Gulf Cooperation Council allies, while only modestly reducing U.S. production. The Saudi economic outlook was being jeopardized by the extended period of low prices. In 2016, for the first time in decades, Saudi Arabia was compelled to borrow on international capital markets in order to slow the drain on its reserve funds. Also in 2016, Qatar borrowed on the capital markets for the first time in its history, and Kuwait ran its first ever budget deficit. All the while, ongoing technological advances in the U.S. continually lowered the ‘break-even’ costs of the U.S. fracking industry. Now, the OPEC agreement is likely to boost U.S. production even further by reviving the fortunes of even the least technologically-advanced U.S. producers.    

The OPEC deal did not resolve the rift between Iran and Saudi Arabia that had prevented an agreement in similar talks earlier this year, and which many predicted would scuttle an agreement at the November 30 meeting. The two powers, who represent the Shi’a and Sunni poles of the Islamic world, respectively, continue to fight a proxy war on several fronts in the region. Iran and Saudi Arabia broke diplomatic relations in January 2016 over Iran’s harsh reaction to the Saudi execution of a dissident Shi’a cleric. The two countries are backing warring sides in Syria and Yemen, and Saudi Arabia has become wary of Iran’s alliance with Russia to keep Syrian President Bashar al-Assad in power. In allowing oil prices to fall since 2014, Saudi Arabia had also hoped to weaken both Iran and Russia economically, thereby undermining their ability to support the Assad regime. That strategy has not succeeded, and Assad now has the clear upper hand in the Syrian civil war. Further, Saudi Arabia’s uncertainty about the policies of the incoming Trump administration on these and other issues served as an additional incentive to reach an oil agreement at the Vienna meeting.


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