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OPEC Compliance and the Great Saudi Boondoggle

Brian Pellegrini, CFA, 19 July 2017

Ecuador announced on Tuesday that it would abandon its OPEC quota and begin increasing output.
We believe Ecuadors move for the exit foreshadows a breakdown of the agreement between OPEC
and several non-OPEC members to restrict production.
Rumors also surfaced that the Saudis are considering a unilateral cut of an additional one million
barrels. It appears that in the ongoing intergenerational transfer of power the hard lessons of the
1980s have been forgotten.
The lessons of failed efforts in the 1980s are plain to see in the data. OPEC drastically cut production
in an attempt to prop up prices, but was unable to stay ahead of the market and eventually prices
collapsed when the cartel capitulated.
Recently it was announced that Nigeria and Libya would be attending the next OPEC technical
meeting to discuss their output plans. Given the fiscal damage to these two producers as a result of
internal conflict and the resulting decline in production, it would seem very difficult for them to
agree to limit production.
The Saudis are also unlikely to find any willingness from the Russians to up the ante with another
cut. As a result of Saudi cuts to customers in Europe, U.S. medium-API sour crudes have flipped
from a premium to Russian Urals grade to a discount. The current discount level is just on the
bubble of making it profitable for oil traders to move exports to Europe.
The high elasticity of U.S. shale producers, low cohesiveness of OPEC, limited ability to coordinate
production with non-OPEC producers and the cash flow constraints of all the major players set up a
prisoners dilemma in the oil market. If the major players cannot coordinate then their next best
option is to maximize market share.
Two important news items regarding OPECs efforts to clear a so-called glut from the global oil market
broke on Tuesday. First, Ecuador announced that it would abandon its OPEC quota and begin increasing
output because, according to Oil Minister Carlos Perez, theres a need for funds in the fiscal treasury
This fits with our long-held thesis that a prisoners dilemma exists in the global oil market 1. All of the
players are cash-flow-constrained and are limited in their ability to coordinate production. As a result, any
attempt by OPEC to manipulate oil prices will fail. However, OPEC members have done an excellent job of
raising the prices of their own grades relative to other grades, resulting in a loss of market share rather
than a substantial increase in prices across all grades.
We believe Ecuadors move for the exit foreshadows a breakdown of the agreement between OPEC and
several non-OPEC members to restrict production. As we have discussed frequently in the past, OPEC is a
paper tiger that is better described as a political club than a cartel. Table A below shows the terrible
1
Our first note on the topic was A Prisoners Dilemma in the Oil Market of 17 June 2015
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compliance record OPEC members have had since the 1980s. Indeed, the nine major OPEC producers
excluding Iraq have collectively cheated on their output quotas 96% of the time. Table B below shows that
the current situation is repeating historical patterns. Five of the eleven members that agreed to cut were
not in compliance in June. True to form, Algeria has not been in compliance since the agreement began.
The headline compliance for the group as a whole was 99.8%, but if we remove the Saudis who
voluntarily cut more than required and Venezuela who involuntarily cut more than required
compliance is down to 98.9%. This might not seem like a shockingly low compliance, but it is the pattern
that matters. Note that the cheaters have all cheated the entire time and that overall compliance dropped
significantly between May and June (Chart 1). Iraq is particularly noteworthy because compliance has
deteriorated significantly and the country is openly discussing further ramping up production this year to
pay for reconstruction costs. We expect that, as has been the case in the past, the good behaviors will
tire of supporting the charts and compliance will continue to deteriorate until the agreement is scrapped.
A B OPEC Compliance ex Saudi and Venezuela
OPEC Noncompliance: 1982 - 2009 OPEC Member Production: Levels vs. Compliance 100.0% 1
% of Months June Target Compliance Mths Compiant 99.8%
OPEC Member Exceeding Quota Algeria 1.060 1.039 98.0% 0 99.6%
Algeria 100% Angola 1.668 1.673 100.3% 6
Iran 72% 99.4%
Ecquador 0.527 0.522 99.1% 0
Iraq* 82%
Gabon 0.197 0.193 98.0% 0 99.2%
Kuwait 90%
Iran 3.790 3.797 100.2% 5 99.0%
Libya 83%
Iraq 4.502 4.351 96.6% 0
Nigeria 88% 98.8%
Kuwait 2.709 2.707 99.9% 5
Qatar 90%
Qatar 0.618 0.618 100.0% 5 98.6%
Saudi Arabia 82%
Saudi Arabia 9.950 10.058 101.1% 6 98.4%
UAE 96%
UAE 2.898 2.874 99.2% 0
Venezuela 77% 98.2%
Venezuela 1.938 1.972 101.8% 4
OPEC-9 (excl Iraq) 96%
* Ira q not a s s i gned a quota a fter Ma r-98 Total 29.857 29.804 99.8% 98.0%
Jan-17 Feb-17 Mar-17 Apr-17 May-17 Jun-17
Source: Col ga n (2014) Ex Saudi & Venezuela 17.969 17.774 98.9% Source: OPEC

The second news headline, likely spawned by the first, was about rumors that the Saudis are considering a
unilateral cut of an additional one million barrels. As we have discussed in prior notes2, any attempt to
significantly cut production would need to be a Saudi affair. The other major OPEC producers simply
cannot afford additional cuts and even some of the GCC members would be risking serious fiscal
deterioration if the cut did not produce a dramatic increase in prices. We also discussed in those notes why
a campaign by the Saudis to prop up prices would be destined to fail. It appears that in the ongoing
intergenerational transfer of power the hard lessons of the 1980s have been forgotten. Discussing the
decision not to cut production in 2014 or 2015, former Saudi Oil Minister Ali Al-Naimi, born in 1935, said in
December 2015 that the experience of the first half of the 1980s was still in our minds. However, in May
2016 the current minister Khalid Al Falih, born in 1960, assumed office and has taken a different position
on the usefulness of production cuts. The assertive new crown prince Mohammed bin Salman was not
even born when the Saudi boondoggle in the 1980s was taking place.
However, the lessons of failed efforts in the 1980s are plain to see in the data. Chart 2 below shows that
OPEC members were never able to regain their pre-1980s share of the global oil market. From a peak of
2
See our notes Will the Saudis Cut Production? Does it Matter if They Do? Parts 1 & 2 of 24 and 27 October 2016, respectively.
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50% in 1973 the level has been around 30% since the late 1990s. Chart 3 below shows the markets
response to the oil price shocks of the late 1970s and 2008-2014. In the late 1970s the oil price shock
contributed to already high inflation and the Volker Fed substantially raised interest rates. The subsequent
recessions and improvements in efficiency (see below for further discussion on this) led to a rapid
contraction of global demand. OPEC drastically cut production in an attempt to prop up prices, but was
unable to stay ahead of the market and eventually prices collapsed when the cartel capitulated. In
contrast, the shock that lasted from 2008 through 2014 prompted a different response 3. Growing demand
for oil from emerging markets prevented global demand for oil from falling as a result of the price shock so
the supply-side responded. Shale production began ramping up in 2011 and the ramp up by OPEC in 2014
led to an outright price crash.
OPEC Oil Exports AS % of Non-OPEC Demand Real Oil Price vs. Global Output: 1968-2016
40% 2 $140 3
OPEC never regained the market share
lost as a result of the cut in the 1980s. 2011 Shale ramps up
$120
OPEC cuts
35% production but price
1979
Price (2015$/bbl)
$100
continues to fall 2014

30%
$80
OPEC dumps
1983 supply on
$60 market
25%
1978

$40
2016
2003
20%
1988
$20
1973
1968
15% $0
1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

2016

40 50 60 70 80 90 100
Global Output (mb/d)
Sources: OPEC, Connolly Insight Sources: BP, Connolly Insight

The demand response in the U.S., on a per person basis, from 1998 through 2016 was remarkably similar to
the response in the 1980s (Charts 4 and 5). Demand intensity fell as a result of the upward price shocks
and did not recover when prices fell. This is not surprising since innovations and efficiency-boosting
measures are not undone as a result of price declines. The response was similar across the OECD. Even if
GDP were to come roaring back in the developed world, demand for oil would not respond in the same way
it would have done in the mid-2000s.

3
Note that in real terms the price of oil in 2011-2013 was higher than in 2008.
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U.S. Oil Demand Response to Changes in Oil Price (1971 - 1997) U.S. Oil Demand Response to Changes in Oil Price (1998 - 2016)
$120 $140
4 5
1979
$120
$100 2012
2008

$100
Real Oil Price (2016$)

Real Oil Price (2016$)


$80

$80

$60 1974
1985
$60
1978
$40 2004
2016
$40
2002
1997
$20
$20
1971 1973 1998

$0 $0
2.0 2.5 3.0 3.5 4.0 4.5 2.0 2.2 2.4 2.6 2.8 3.0 3.2 3.4
Sources: BP Statistical Review, Bloomberg, Connolly Insight Oil Demand (tons / person) Sources: BP Statistical Review, Bloomberg, Connolly Insight Oil Demand (tons / person)

Recently it was announced that Nigeria and Libya would be attending the next OPEC technical meeting to
discuss their output plans. Other producers have been making statements recently implying that a
production cap should be imposed on the two countries by OPEC. Given the fiscal damage to these two
producers which has been the result of internal conflict and the resulting decline in production, it would
seem very difficult for them to agree to limit production (Chart 6). Reports have surfaced that Libya had
increased production by another 300 thousand barrels per day in July, bringing output to 1.1 million barrels
per day. However, even that level is 440 thousand barrels below a 4.6% cut from the pre-war peak of 1.6
million barrels per day4. In addition, Egyptian and UAE oilfield drilling and services companies are
reportedly chomping at the bit to get into the Libyan market; given the importance of both those countries
for the Saudis in their efforts to contain Iran, it seems unlikely they would ask them to limit much-needed
private sector revenue5. As for Nigeria, its production is 200 thousand barrels per day below a cut of 4.6%
from its January 2016 level. The potential for further production recovery in these two countries remains a
serious threat to any effort by OPEC to further limit the output of the cartel.
The Saudis are also unlikely to find any willingness from the Russians to up the ante with another cut.
Indeed, the Russians must be getting nervous about the possibility that U.S. exports are attracted to their
cash-cow markets in northwestern Europe. As a result of Saudi cuts to customers in Europe, U.S. medium-
API sour crudes have flipped from a premium to Russian Urals grade to a discount (Chart 7). The current
discount level is just on the cusp of making it profitable for oil traders to move exports to Europe. Any
further production cuts by Russia would likely provide room for U.S. imports, which would fuel further
production by the U.S. and completely undermine any efforts by the 22 nations that entered into the
agreement in an effort to manipulate global prices.

4
The 4.6% number is consistent with the cuts agreed to by other members in November 2016.
5
See our notes Escalating Risks in the Middle East, Parts 1, 2 and 3 of 1, 8 and 19 June, respectively, for a discussion on the political
constraints faced by the Saudis in their efforts to contain Irans regional ambitions.
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Nigeria and Libya Crude Oil Production (millions bbl/d) U.S. Argus Sour Index vs. Russian Urals Blend
3.0 6 $5.00 7
U.S. at Premium
Libya Nigeria
$4.00
2.5
Still 200kb/d short of 4.6% $3.00
cut from Jan 2016 level
2.0 $2.00
Further production
cuts could draw sour
$1.00
grades to Europe
1.5
$0.00
July production of 1.1mb/d is
still 440k barrels from a 4.6% cut
1.0 -$1.00

-$2.00
0.5
-$3.00

U.S. at Discount
0.0 -$4.00

May-16

Apr-17
Apr-16

Dec-16
Jun-16

Aug-16

Oct-16

Mar-17

May-17
Nov-16

Jan-17

Jun-17
Jul-16

Sep-16

Feb-17

Jul-17
Apr-10

Jan-11
Apr-11

Jan-12
Apr-12

Jan-13
Apr-13

Jan-14
Apr-14

Apr-15

Apr-16

Apr-17
Jan-10

Jul-11

Jul-12

Jul-13

Jan-16

Jan-17
Jul-10
Oct-10

Oct-11

Oct-12

Oct-13

Jan-15
Jul-14
Oct-14

Jul-15
Oct-15

Jul-16
Sources: Bloomberg, Connolly Insight Oct-16 Sources: Bloomberg, Connolly Insight

Conclusion
We believe market participants should look past Saudi jawboning and focus on the market dynamics
pushing against any efforts by OPEC to manipulate prices. The high elasticity of U.S. shale producers, low
cohesiveness of OPEC, limited ability to coordinate production with non-OPEC producers and the cash flow
constraints of all the major players set up a prisoners dilemma in the oil market. If the major players
cannot coordinate then their next best option is to maximize market share. Tuesdays announcement by
Ecuador that it will no longer limit production and poor compliance by other OPEC members signal that the
agreement to limit production by OPEC and several non-OPEC countries is unraveling. Libya and Nigeria are
unlikely to agree to limit production at a level so far below their pre-disruption output and Russia will be
hesitant to cut further for fear of drawing U.S. exports of medium-sour grades to Europe. Any attempt by
the Saudis to make a large unilateral cut might produce a short-lived jump in prices, but it will only be
setting them up for longer-term pain as the cut opens up additional market share for U.S. exports and for
other producers not bound by the agreement to limit production.

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