Kemp: After Two Years, Why An OPEC Deal Now?

Kemp: After Two Years, Why An OPEC Deal Now?
OPEC has finally agreed to cut production, but only after two years of fruitless negotiations. So what changed?

Indispensable Nation

Saudi Arabia is not like other members of OPEC. Saudi Arabia has always been the indispensable nation without which no agreement is possible.

"Saudi Arabia is more influential than other OPEC members," wrote Anas Alhajji and Michael Huettner in what remains the classic short study of the organisation ("OPEC and other commodity cartels", 2000).

"Saudi Arabia meets all the characteristics of a dominant producer by having relatively large market share, excess capacity, flexible behaviour (and) the ability to move its price by increasing or decreasing production."

"No other OPEC member has similar behaviour. Therefore Saudi Arabia should be treated on its own within OPEC," they concluded.

"Some of the confusion surrounding OPEC behaviour has been caused by mistakenly assigning the power of Saudi Arabia, along with its Gulf allies, to OPEC (as a whole)."

Market Share

Saudi officials have stated consistently the kingdom will not sacrifice market share to other producers - whether U.S. shale firms, OPEC rivals such as Iran and Iraq, or non-OPEC competitors such as Russia.

Saudi officials refused to cut output during 2014 and 2015 for fear that any price increase would simply throw a lifeline to U.S. shale firms and encourage them to raise their production. Since May 2015, however, U.S. oil production has been falling, eliminating one source of competition.

Saudi Arabia continued to refuse to cut output during 2015 and the first half of 2016, citing the threat of increased production from Iraq, Iran and Russia. But by the summer of 2016, Iranian output appeared to have reached a temporary plateau following the lifting of sanctions, reducing the threat from that quarter.

The main challenge to Saudi market share now comes from Iraq and Russia, both of which have increased their output this year. But Saudi officials may have concluded the scope for further increases in the short term was modest and that an agreement to freeze Iraq's and Russia's output around current levels would be viable.

Market Power

Saudi officials have usually assumed, with justification, that other OPEC and non-OPEC members will cheat on any production agreement if they can. But sometimes other OPEC and non-OPEC countries are unable to cheat because of war, sanctions, social unrest or lack of investment, which makes deals possible.

Between 2014 and 2016, Saudi Arabia had no incentive to cut production because other countries were likely to respond by increasing their own output. Riyadh would have been left with lower output and unchanged or lower prices, resulting in lower revenues. Output cuts were not an optimal strategy for the Saudis.

But with Iran's output apparently peaking in the summer of 2016, opportunities for cheating have become more limited. Most other OPEC members are struggling to maintain current production and have few options to raise output.

The main challenge comes from further increases in output from Iraq and Russia, and both countries have agreed to freeze or cut their output under the November agreement. Given output from other sources is now maximized or frozen, Saudi Arabia's optimal strategy is to reduce output and secure an increase in prices.

1999 Output Deal

The circumstances for an output deal are somewhat similar to those which facilitated the successful output-cutting deal of March 1999 between OPEC and certain non-OPEC countries.

"Lower capacity prevented OPEC members from cheating and prevented non-OPEC members from increasing their production," after March 1999, Alhajji and Huettner explained shortly afterwards.


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