Expectations Grow on Saudi Oil Meeting; Greater Consumer-Producer Reciprocity Indicated

Setting the Stage for Reciprocity

Saudi Arabia added 500,000 b/d of additional crude output to the global markets in just over a month, with 300,000 b/d of the increment onstream since mid-May and the remaining 200,000 b/d promised from the beginning of July (see World: 16 June 2008: Oil Prices Retreat Slightly on News of Imminent Saudi Arabian Oil Output Boost). The increased output, coming at a time when the kingdom by and large supported the OPEC-wide outlook of global supply and demand being balanced, was driven by a reaction to the tremendous political pressure Saudi Arabia has come under—being OPEC's main swing producer—from both Western and Asian consumer nations. It has also been a reaction to traditional long-term Saudi fears of high prices leading to demand destruction, threatening its long-term interests.

The announcement of the producer-consumer conference, to be held on Sunday (22 June) in Jeddah, was initially met with a lot of scepticism given its undefined brief and agenda, as well as the lack of concrete proposals to be discussed. However, expectations on the meeting have since risen, as Saudi Arabia has signalled its sincere willingness to bring down crude prices in order that consumer markets and the world economy not suffer (see Saudi Arabia: 11 June 2008: International Oil Meet Set for 22 June; High Price Blame to be Shifted from Producers and World: 18 June 2008: Iran Criticises Unilateral Saudi Crude Production Hike; OPEC Unity at Stake?). Committing to raising production in a situation where supply and demand on a current basis is matched puts the onus on all other participants to approach the conference with similar levels of pragmatism and a readiness to act reciprocally.

The Back Door to Success

True to form, the Saudis have reportedly worked the diplomatic back channels overtime since launching the Jeddah meeting. Always showing preference for direct talks outside of the media limelight—in the vein of traditional-style negotiations where consensus-building takes place beforehand during private talks, while only positive results and the consequential unity are demonstrated outwards—they have been eager for a core understanding to be reached between all attending parties beforehand.

Hence, the timing of China's domestic fuel price hike might not be seen as that surprising, given its interest—as one of the fastest-growing consumers—in reaching a comprehensive deal to bring down prices (see China: 20 June 2008: Shock Fuel Price Increase in China as NDRC Opts for the Lesser of Two Evils). China was otherwise widely seen as preferring to wait with the domestically unpopular decision until after the summer Olympic Games, which its capital, Beijing, is hosting.

The United Kingdom's Prime Minister Gordon Brown has also indicated a similar willingness to reach consensual results, reportedly flying to Jeddah with a proposal to allow for easier investment opportunities in Western companies for OPEC members' sovereign wealth funds, in exchange for greater openness to IOC investment in the OPEC states' upstream sectors. The proposal, reported by U.K. newspaper the Daily Telegraph, would appear to combine two of the main concerns both for Middle Eastern producer nations, having to invest their huge crude export windfalls in increasingly wary Western economies, and for Western—and Asian—consumer nations, whose NOCs and IOCs face an increasing struggle to gain access to promising oil and gas plays. The proposal could also lead to greater efficiency of investment in oil and gas fields in several of the OPEC states, whose NOCs have fought to keep up to speed with technological development and expertise, far too often having had to play the role of government cash-cow and being left unable to pursue long-term investment programmes of a necessary scale.

Additional Volumes Up Their Sleeves?

There has also been widespread speculation that Saudi Arabia might be in the process of raising its production even more as the meeting gets under way, in order to force a substantial decline in crude prices on the market. A press release published yesterday—apparently accidentally—on the kingdom's U.K. Embassy's web site, and then withdrawn, announced a 200,000-b/d increase, and could perhaps be interpreted as a Saudi back-up option should the markets continue to go up—or alternatively, a poorly worded confirmation of the already-promised July increase.

Saudi Arabia will have to convince representatives from consumer state and the oil industry, as well as the watching world market, that it and its fellow OPEC members have the potential to supply growing volumes of crude over the coming years. Currently the kingdom maintains that it has an 11.3-million-b/d production capacity (rising to 12.5 million b/d next year), with recent raises taking its July production to around 9.65 million b/d. The problem for Saudi Arabia, and indeed everyone else, is that virtually all of the spare capacity consists of heavy oil, which the fast-growing Asian markets' refineries are unable to absorb. Arabian heavy oil, produced in large quantities by the kingdom, Iran, and Kuwait, for instance, is already trading at very large discounts to more easily refined crudes. The heaviest and sourest variations, such as Iran's Nowruz/Soroush crude, are even building up huge backlogs (see Iran: 9 May 2008: Large Backlog Builds as NIOC Experiences Difficulties in Selling Iranian Heavy Crude).

Nonetheless, Saudi Arabia is bringing the 500,000-b/d Khursaniyah field onstream in July, after a six-month delay due to construction material and skilled engineer shortages, and is likely to use its increment of lighter crude as a guarantee—committing unofficially to putting an upper cap on the crude prices during the meeting.

Drawing OPEC Hawk Ire

Saudi Arabia's switch of stance, aligning its oil policy with the consumer nations to bring down crude prices, has drawn some criticism from OPEC's main price hawks, in an all-too-familiar fashion. Iran has criticised Saudi Arabia's unilateral production hikes, while Venezuela has snubbed the Jeddah meeting altogether, in what—with OPEC standards and given the Saudi investment into the success of the meeting—is likely to create a bit of bad blood between the countries (see World: 19 June 2008: Venezuela Snubs Saudi Oil Meeting While Number of Oil Executives Attending Grows).

OPEC's sidelining should not be overplayed, however, as Saudi Arabia in the past has chosen whether or not to act through the cartel depending on the outcomes it seeks. Few of the cartel's members have the same long-term demand-defence outlook as Saudi Arabia, and given the position the country has in the organisation—currently only Saudi Arabia and to a small extent the United Arab Emirates have spare capacity—the importance that OPEC carried until the unilateral Saudi hikes will be restored as soon as Saudi Arabia sees a need to again defend the oil price from falling further; given the potential oversupply of the market in the coming months, this might be relatively soon.

Outlook and Implications

The Saudis are likely to keep a very close eye on the supply-and-demand balance in the coming days and months in order to achieve the cooling-down of the frenzied oil markets and bring prices to a level where demand destruction is not feared. If that happens, it is likely to switch its policies back to OPEC mode, using the cartel's framework to withdraw sufficient supplies to halt a slide.

The kingdom seems to have facilitated a significant swing of expectations, from widely negative to much more positive, in anticipation of the meeting during the past week, having used the back channels to build consensus and perhaps even float the outlines of a joint declaration between the meeting's principals. Its manoeuvring capacity is, however, fairly limited, particularly with regard to allowing greater scope for private investment in its own upstream sector, seen as a non-starter for domestic political reasons. Instead Saudi Arabia will try to point to a lot of investment going on among OPEC nations and to potentially huge Iraqi future production rises. It will also urge Asian countries—especially China—to make it easier for Gulf NOCs to build refineries and market fuels in its domestic market, by adjusting their subsidy regimes. This could in the medium-to-long run lift Asia's capacity to refine and absorb heavy oil, easing some of the current shortage for lighter grades.

Find out more about Same-day Analysis