Here's the real reason Saudi Arabia wanted to cut oil production

AP/Hasan Jamali

Saudi Arabia surprised the world by helping to engineer an unexpectedly strong agreement from OPEC members to cut production by 1.2 million barrels per day, followed by additional cuts from non-OPEC members. While the two agreements incorporate cuts from a wide range of oil producers, Saudi Arabia will do much of the heavy lifting, cutting nearly 500,000 barrels per day and even promising to go further than that should the markets warrant steeper reductions.

Depending on one’s perspective, Saudi Arabia demonstrated its diplomatic prowess and made OPEC relevant again, succeeding in talking up oil prices without sacrificing much. After all, Saudi Arabia often lowers production in winter months. Other analysts look at it a different way – Riyadh was actually pretty desperate for higher oil prices, given the toll that the two-year bust has taken on the country’s economy. That led Saudi Arabia to shoulder most of the burden of adjustment, achieving only small concessions from other OPEC members, most notably Iran. Riyadh was the big loser of the deal, the thinking goes, but ultimately had no choice as the government needed higher oil prices.

There are arguments to made for both sides, but then there is a third possibility: Saudi Arabia was motivated to pullback because it was actually leaning on its oilfields too hard this year when it pushed output up to 10.7 million barrels per day, an output level that might have strained the reservoirs of some of its largest fields. Producing too aggressively can ultimately damage the long-term recovery of oil reserves. Reuters reports in an exclusive report that Saudi Aramco could have been pushing its oil fields to the limit this year, and had little choice to but to climb down from record high output levels.

Saudi Arabia has long maintained that it could ratchet production up to 12 mb/d or more if it wanted to, but such a massive rate of production has never actually been proven or even tested. Reuters raises the possibility that Saudi Arabia might not actually have the ability to go that high. A source told the news organization that Saudi Aramco might only be able to produce at 11.4 mb/d, and going beyond that level would require billions of dollars in new investment in several years of development.

But making the enormous investments needed to take its production capacity up to 12 mb/d at a time when government coffers are depleting led Saudi officials to the conclusion that it needed to take a breather, sources told Reuters. With its oilfields feeling the strain, Saudi Arabia saw an urgent need to dial back output a bit, which made it particularly determined to strike a deal with fellow OPEC members. The prospect of higher oil prices ultimately made the promised production cuts seem like much less of a sacrifice.

The question surrounding how much oil Saudi Arabia can ultimately produce if it completely opened the taps is not an academic one. Saudi Arabia is the one country in the world that is thought to have a substantial volume of capacity sitting on the sidelines for the purpose of being called upon when oil markets need additional supply in a pinch. Every other country and company pretty much produces flat out save for a few small exceptions. This “spare capacity” is a major buffer for oil price volatility, as the markets rest assured that Saudi Arabia will plug any supply deficit from an unforeseen outage such as natural disaster (Hurricane Katrina) or conflict (war in Iraq).

But Saudi Arabia is secretive about the details of its industry and capabilities. The operating assumption that Saudi Arabia can ultimately produce 12 mb/d is the basis for calculating OPEC’s (and thus, most of the world’s) spare capacity.

Riyadh’s strategy of abandoning price stability and going for market share in 2014 led to a ramp up in production. Output hit a record this year at 10.7 mb/d. That necessarily led to a drawdown in spare capacity, dropping near 1 mb/d, the lowest level in years. Historically, oil prices have spiked when spare capacity runs low. Since 2014, however, the world has been awash in oil, and rising inventories acted as a second source of spare capacity, dampening any concerns about the effects of an unexpected outage.

AP/Hasan Jamali

However, the oil markets could be in a tighter situation than many have expected if Saudi Arabia can’t actually produce at 12 mb/d. Oil consultancy PIRA says that the kingdom could produce 10.5 mb/d on short notice, and anything higher would damage oil fields. "Saudi Arabia could produce more but it would likely come at the expense of optimal reservoir practices. They could certainly bring on new fields but this is a lengthy process (years) and expensive as well," PIRA says, according to Reuters. "So far the kingdom is not adding any significant new producing capacity based on project announcements and rig activity but rather replacing the aforementioned 4 to 6 percent annual decline rate."

Again, since oil inventories are so high, it is not as if the world is in danger of a shortage if an outage occurs. Storage levels are so high that they will take time to come down. Nevertheless, if Saudi Arabia can produce a lot less oil than previously thought, that adds to concerns about the security of supply over the longer-term.

We will find out a bit more about Saudi Arabia’s oil secrets when it releases financial data related to Saudi Aramco in anticipation of its partial IPO in 2018.

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