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Saudi Arabia cannot escape destiny as swing producer

February 2, 2017 at 4:04 am

King of Saudi Arabia Salman bin Abdulaziz [Bandar Algaloud/Handout/Anadolu]

Saudi Arabia has been forced to return to the role of swing producer in the oil market, despite the country’s insistence for three decades it would never play the role again.

Saudi Arabia and its allies in the Gulf Cooperation Council (GCC) account for the majority of production cuts made so far under the OPEC and non-OPEC accords reached in November and December.

By cutting their own output deeply, Saudi Arabia and its allies have masked the low level of compliance from the rest of the organisation.

Outside OPEC, Russia has so far delivered only around a third of its promised cut of 300,000 barrels per day (bpd), according to sources.

Russia and other producers have always pledged to phase in cuts, which are meant to be averaged over the first six months of 2017.

Strictly speaking, OPEC and non-OPEC members have not yet failed to honour their promises since they could reduce output more steeply in the remainder of the compliance period.

But Saudi Arabia and its GCC allies have once again supplied most of the upfront cutbacks, reducing their production by enough to create a deficit in the market and draw down excess crude inventories.

Adjusting production to bring about a desired balance between supply and demand, or achieve a particular target price, is the classic role of a swing producer.

Saudi Arabia has been forced back into the role, despite insisting since the mid-1980s it would never assume the burden again.

March 1983

Saudi Arabia only officially played the role of swing producer for a short period in the early 1980s, when it failed to stem the oversupply of global oil markets and slide in prices.

The Organization of the Petroleum Exporting Countries began setting an overall production target and allocating it among members at its ministerial conference in March 1982.

The initial target for the group as a whole was set at 17.5 million bpd and Saudi Arabia’s share was set at 7.150 million bpd.

One year later, in March 1983, OPEC revised the allocation system and Saudi Arabia formally assumed the role of swing producer, varying its output to balance supply and demand.

Ministers agreed “to establish a ceiling for total OPEC production of 17.5 million barrels per day, within which individual member countries were allocated,” according to the communique issued afterwards.

“No quota is allocated to the Kingdom of Saudi Arabia, which will act as a swing producer to supply the balancing quantities to meet market requirements” (“Communique by OPEC”, New York Times, March 1983).

Saudi Arabia had often acted as an informal swing producer, but this was the first time the role had been formalised.

Saudi Arabia’s role as a swing producer formally terminated in 1984 when it opted instead for a quota of 4.35 million bpd, though in practice it went on performing the swing producer role until September 1985.

“I have a strong feeling that this will work out and that OPEC will be in the driver’s seat,” Saudi oil minister Zaki Yamani told a news conference after the March 1983 meeting.

But the following three years proved difficult for Saudi Arabia as other OPEC members cheated on their quotas, rival suppliers outside OPEC continued to raise their output, and oil prices fell.

Saudi Arabia cut its output to balance the market and shore up prices to no avail, and then switched to a netback pricing system to recapture lost market share, sending prices tumbling to $10 per barrel.

Never again

Yamani was sacked in October 1986 and replaced as Saudi oil minister by Hisham Nazer, who ruled out any return to acting as a swing producer (“Nazer rules out swing producer role for Saudi Arabia”, Middle East Economic Survey, Sep 1987).

“We will conscientiously support OPEC … but we will not appoint ourselves custodians of the policies of OPEC, nor will we be willing to play the role of swing producer at all”, Nazer said in an interview in September 1987.

Nazer’s successor as oil minister, Ali Naimi, was even blunter:

“Saudi Arabia tried in the past to play the role of the swing producer by reducing production to maintain a specific price, but the result was unfavorable to the kingdom,” he said in an interview in March 1998.

“Despite the fact that its production fell from more than 10 million bpd in 1980 to less than 3 million bpd in 1985, prices collapsed. As a result, the kingdom not only lost in terms of prices but also lost its market share at that time.”

“We have abandoned once and for all the role of swing producer,” Naimi said (“Saudi oil minister spells out kingdom’s views on current oil market”, Middle East Economic Survey, March 1998).

No escape

In practice, giving up the role of swing producer has proved impossible, however much the country’s policymakers loathe it.

In March 1999, Saudi Arabia was again taking the lead in cutting production to shore up prices after the Asian financial crisis.

Saudi Arabia and its GCC allies ended up providing most of the production cuts that helped drain excess stocks and push prices higher in 1999 and 2000.

“The only country that reduced production voluntarily, according to the March agreement, is Saudi Arabia, with marginal help from Kuwait and the UAE, while all other oil producing countries were forced to reduce their production because of technical, political, or natural factors,” Anas Alhajji and David Huettner wrote shortly afterwards (“OPEC and other commodity cartels”, 2000).

In the most recent round of cuts, agreed in November and December 2016, Saudi Arabia and the GCC are again shouldering the biggest share, despite spending months insisting this is what they would not do again.

Saudi burden

The problem is that the role of swing producer is not one that Saudi Arabia’s policymakers have voluntarily accepted, but one which has been thrust upon them.

Saudi Arabia is the only producer that exports enough and has the centralised control to exercise some degree of market power in the oil market.

Other major oil producing countries are net importers, or their production is split among many small independent companies, or is too small to have much influence on global prices.

Saudi Arabia is the only country that has production centralised in one company (Saudi Aramco) and exports enough to have a major influence on global prices (7-8 million bpd).

Saudi Arabia is also a low cost producer which has the operational flexibility to adjust its production up or down by several million barrels per day.

Saudi Arabia is therefore the only country that can to some extent choose a production target or a price target, though importantly not both.

For structural reasons, Saudi Arabia is always the swing producer in the crude oil market, whether it welcomes the role or not.

Punishment

Saudi Arabia’s operation as the swing producer in the oil market was modelled in a series of workshops run by Shell more than a quarter of a century ago (“Modelling the oil producers”, Morecroft and Heijden, 1990).

According to the workshop, which brought together experts from across the oil industry together with systems modellers, the swing producer can operate in two modes: “normal swing mode” and “punitive mode”.

In normal mode, the swing producer adjusts its output to balance supply and demand and keep prices close to an intended target.

“In punitive mode, the swing producer feels that his production is inadequate – he is not getting a fair share of the market or is receiving too little revenue – and so decides to re-establish his position by punishing the other producers.

“In the model, the swing producer has a threshold below which he is unwilling to allow market share to fall. When market share falls below the threshold, the swing producer sets a new and higher volume of production that floods the market and quickly lowers the price.

“The switch to punitive mode can send a powerful price signal to discipline the other producers, but is an act of last resort because in this mode the swing producer has abandoned the role of price regulator, essentially the market is no longer managed”.

The model describes Saudi Arabia’s recent behaviour reasonably well.

Between 2014 and the first half of 2016, the kingdom operated in punitive mode, focusing on defending market share and allowing prices to fall.

In the second half of 2016, however, the kingdom switched back to swing mode, and is now adjusting production to achieve a desired reduction in stock levels and firming prices.

The views expressed in this article belong to the author and do not necessarily reflect the editorial policy of Middle East Monitor.