Will OPEC’s obstinate stand cause long term harm?

If the recent slump in oil prices from $115 a barrel in June 2014 to $60 now (having touched $45 back in January) has proven one thing, it is that OPEC’s medium term strategy (led by Saudi Arabia) to undermine the United States’ shale industry, by increasing production has largely been working.

Yet raising output to undercut US shale, even factoring in higher production costs over there, is still a costly exercise for Gulf states strongly dependent on oil export revenues. Especially as they simultaneously try to reposition their economies away from such over-reliance.

Unsurprisingly, the knock-on effect is Gulf Cooperation Council states now face budget issues in some instances.

Budgetary constraints may be the new reality but their impact across the region varies.

Analysis in April from Abu Dhabi Commercial Bank, for example, showed that while project awards in Q1 2015 were 10 per cent higher year-on-year across the GCC as a whole, Oman and Bahrain – the two states whose fiscal balances are most impacted by lower oil prices – saw slumps of 43 per cent and 20 per cent respectively. In the United Arab Emirates meanwhile, lower real estate valuations in part contributed to a 36 per cent year-on-year fall in awards.

Even in Qatar and Kuwait, where gains of 287 per cent and 72 per cent respectively were recorded, ongoing infrastructure requirements – ahead of the 2022 FIFA World Cup in Qatar – had a significant impact in its case and will have distorted the overall economic picture.

Budget break-even thresholds (Kuwait and Qatar accepted) are currently above crude spot prices; translating into fiscal deficits should current trends continue, according to Deutsche Bank.

In its May 2015 report: GCC in times of cheap oil the bank estimated the current oil price needed to prevent a state slipping into fiscal deficit ranged from $49 per barrel in Kuwait to $119 in Bahrain. Corresponding thresholds for Qatar, the UAE, Oman and Saudi Arabia were $56, $63, $90 and $105 per barrel respectively.

Not at all states will witness fiscal deficits immediately and break-even thresholds do not tell the full story in any event.

Saudi Arabia, for example, may currently be running a budget deficit. But with estimated foreign currency reserves of $683bn as at end-April 2015, according to Saudi investment firm Jadwa, it has more than sufficient asset buffers and easy access to financial markets to cope with any shortfall for now.

Those with smaller asset buffers, on the other hand, have been forced to manage down the value of their currencies in order to preserve the local currency value of their oil revenues.

Having spent its way through $49bn worth of reserves in the January-April 2015 period alone, Jadwa is forecasting Saudi Arabia will post a budget deficit this year of $107.7bn, compared to official government forecasts of $39bn. A significant chunk of this ($30bn) will be the expected cost of King Salman’s decision in January to give Saudi state employees an extra two months of pay and a pension bonus to retired government workers.

While current reserves will allow the Saudis to maintain public investment and sustain economic growth, growing pressure on reforming the public finances – in terms of cutting subsidies, coupled with the possibility of raising taxes on the revenue side – is increasingly likely, should the ‘cheap’ oil strategy be pursued for too long.

On the positive side it could accelerate long required economic reforms and reduce the nation’s dependency on oil revenues.

Irrespective of the size of a nation’s asset buffers a fiscal time bomb is ticking across the region nonetheless. The World Bank in April estimated that the fall in crude prices could cost the GCC $215bn this year – equivalent to 14 per cent of the region’s combined gross domestic product.

As a result, the region as a whole may yet record a fiscal deficit for the first time since 2011.

Against this backdrop, the jury is out on whether the global economy is entering a ‘surplus oil’ phase or will remain stuck in a demand deficit over the short to medium term.

Standard Chartered, taking account of a drawdown in US stockpiles ahead of the summer driving season, for example, sees the global crude market shifting to deficit by Q4 2015.

US investment bank, Sanford Bernstein concurs, forecasting demand to outpace supply by 1.5 million barrels a day over the same timeframe. Principally due to US production growth (predominantly from shale) coming to an end, in turn leading to a significant tightening of the market.

Standard Chartered sees benchmark Brent at $90 a barrel by Q4 2015 and West Texas Intermediate at $84. Bernstein meanwhile, is forecasting Brent to rise to $80 a barrel in the short-term and WTI at between $70 and $75 a barrel.

OPEC’s May 2015 report, in contrast, showed Saudi Arabia boosting oil production to 10.31 million barrels a day – its highest in almost three decades, up from 10.29 million barrels the previous month and 700,000 barrels a day higher than Q4 2014.

Further evidence of the ongoing standoff between OPEC and US shale came in a separate report. The International Energy Agency noting that in mid-May, after months of cost cutting and a 60 per cent slump in the US rig count, Light Tight Oil production had gone into reverse the previous month, bringing a multi-year winning streak to an apparent close.

Part of the problem lays in the fact that OPEC’s strategy in general and the GCC’s in particular, may end up being self- defeating if fails to deliver a knockout blow to US shale. Especially given the plausibility of crude prices moving higher on the back of global demand growth in the medium term.

Even OPEC’s own numbers paint a contradictory picture. Global economic growth for 2015 has now been revised down to 3.3 per cent from 3.4 per cent previously, in the organisation’s recent report – in part due to a forecast downward revision in US growth to 2.6 per cent from 2.9 per cent.

But world oil demand growth is still projected to rise at a slightly higher 1.18 million barrels a day, compared to growth of 960,000 barrels a day in 2014.

Demand for OPEC crude in 2015 is now expected to be 29.3 million barrels a day, after a slight upward adjustment from the previous month; representing a gain of 300,000 barrels a day over the 2014 estimate of 29 million barrels a day.

The IEA meanwhile sees global oil demand growth of around 1.1 million barrels a day for this year, taking average total production up to 93.6 million barrels a day, slightly higher than 2014’s 700,000 barrels a day expansion.

The principal driver behind this acceleration is a switch in Organisation for Economic Cooperation and Development demand showing a 460,000 barrels a day decline in 2014 to a gain of 175,000 barrels a day in 2015. Reflecting an improvement in the OECD economic outlook (at least) and colder-than-year- earlier winter weather conditions in Europe in Q1 2015.

These are hardly earth shattering gains. But they nonetheless highlight the uncertainty of oil market price trends going forward, especially if global demand growth either overshoots or undershoots the latest available projections.

US investment bank Jefferies put it succinctly when it recently raised its average oil price forecast for Brent and West Texas Intermediate to an average $60 and $55.10 a barrel from $52.50 and $48.60 previously.

It noted the various competing bear and bull signals, given the two million barrels a day oversupply in the market in the near term, that could yet be exacerbated by a rapid increase in Iranian production should sanctions be lifted there, for example.

Yet this could end up being more than counterbalanced by stronger than expected demand, a pause in the recent rise in the US dollar and continued robust refining margins.

Assuming OPEC keeps pumping oil at current levels through Q3 2015, it will amount to the longest running market glut since 1985. That would imply global oversupply (counting OPEC and non- OPEC output) equivalent to one million barrels a day in the third quarter, 600,000 barrels in the following three months, according to IEA projections.

What is clear though is the impact of OPEC’s pricing strategy on US shale production – this reflected in a reduction of rig counts now working their way through to lowered production after what is typically a six-month time lag.

After forecasting a 57,000 barrels day decline in May, the IEA raised this figure to 86,000 barrels a day fall in output in June.

Meanwhile, late May data compiled by Bloomberg showed US crude inventories shrinking for a fourth straight week, having previously surged to their highest in 85 years.

These numbers are unlikely to prove game changing in the short term when it comes to reducing the global oil glut, but the willingness of OPEC to inflict further pain on the US shale industry may have more profound consequences later on. Much will depend upon global economic growth metrics.

Depending on the latter outcome the question is whether to abandon the strategy on the grounds it would be akin to flogging a dead horse. At the same time budgetary strains and burning into foreign currency reserves may just concentrate a few minds.