OPEC’s Doctrine of Mutually Reassured Destruction

(Bloomberg Opinion) -- OPEC+ has a new sheriff in town, apparently. .After the debacle of early March, Saudi Arabia’s Energy Minister Prince Abdulaziz bin Salman has seemingly imposed order on his unruly posse, securing an extension of deep supply cuts. Most notably, habitual target busters such as Iraq will now be held to account by having to make up any lack of discipline with deeper cuts down the road..But what has changed, really?.OPEC+, like OPEC before it, operates under a doctrine of mutually assured destruction. Any member that doesn’t abide by production quotas runs the risk of annoying fellow members – especially Saudi Arabia – to the point where those members abandon their own commitments, flooding the oil market to the detriment of all. This tactic extends to non-OPEC members, too, as the group can decide to open the taps to punish external producers that get too exuberant..The problem with this type of oil weapon is the mutual bit: It’s more of a nuclear blast than a surgical strike. Everyone suffers the fallout. That didn’t change this weekend. The added dictum of members being punished if they don’t make up shortfalls to their commitments at a later date represents a new trigger, not a new weapon. The pact of mutual destruction has been reassured..There has always been a performative dimension to OPEC in its various guises. This aspect has been especially pronounced this year. Only three months ago, Saudi Arabia and Russia began a price war after disagreement over the need for further supply cuts to meet the challenge of Covid-19. A month later, they reversed and agreed to a truce as OPEC+ announced deep cuts to production, with President Donald Trump inserting himself as broker. Yet the prime mover in that turn of events wasn’t Trump or Prince Abdulaziz. It was a virus..That hasn’t changed. Oil demand is rising back from the abyss, and surprisingly positive U.S. jobs numbers released Friday added to a growing sense of optimism that has pushed Nymex crude oil from about negative $40 to almost positive $40 in the space of seven weeks. But the economic damage inflicted by Covid-19 is deep; how else could U.S. unemployment above 13% suddenly be regarded as a win? Second-wave risks remain, as do other ills facing the oil market, such as the Sino-U.S. trade war, which Covid-19 has exacerbated if anything. In other words, OPEC+ cohesion, lost and then suddenly restored, is a function of a common enemy: the virus..Coming into the pandemic, OPEC+ faced a dilemma. Most of its members, including Saudi Arabia, aren’t built for oil prices below $60 a barrel. Yet $60-plus oil encouraged more output from non-members, especially U.S. shale producers. Deploying the oil weapon in 2014 certainly hurt shale, but an infusion of new capital enabled it to weather the storm. Meanwhile, the economic fallout blew back on OPEC to the point where it not only abandoned that strategy, it acknowledged defeat by throwing in its lot with Russia and a few others to form OPEC+. Since then, it has been trading away market share for higher, but still inadequate, oil prices, which was one reason why Russia bridled at further cuts in March..One thing that is helping OPEC+ this time around is that shale’s own track record of dismal returns means a bailout from the stock market or bondholders isn’t forthcoming this time. The fracking industry is cutting output swiftly and must consolidate, meaning future production growth is likely to be subdued compared to the pre-crash pace..Yet the basic contours of the OPEC+ dilemma are intact. Its members remain dependent on oil and need prices far higher than today’s levels to fund themselves. They must withhold supply to drain the glut of inventory that has built up. Yet with higher prices, the temptation of countries such as Iraq or Nigeria to bust through targets to shore up stability will be irresistible..Meanwhile, shale producers will emerge from rationalization less exuberant than they once were but still more than able to take advantage of a rally. In response, OPEC+ would have to resort to the same method of discipline it has before: flooding the market until everyone, its own members included, struggle to breathe. One added complication: Trump’s damaged electoral prospects mean he is likely to threaten security consequences for Riyadh if it does anything to hurt shale producers in red states this summer..On Monday morning, Prince Abdulaziz spoke of OPEC+ adopting “central bank” tactics in managing the oil market. But central banks can intervene in financial markets in multiple ways, and they also tend not to threaten destruction. In contrast, OPEC+ can either raise oil output or curb it. It is the lack of economic flexibility inherent to OPEC+ members that leaves the group with only the bluntest of tools at its disposal. Faced with an inscrutable enemy like Covid-19, it’s doing about as well as it can. Don’t mistake that for anything more elaborate..This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners..Liam Denning is a Bloomberg Opinion columnist covering energy, mining and commodities. He previously was editor of the Wall Street Journal's Heard on the Street column and wrote for the Financial Times' Lex column. He was also an investment banker..©2020 Bloomberg L.P.

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OPEC’s Doctrine of Mutually Reassured Destruction

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