Article / 03 February 2016 at 0:40 GMT

Saudi self-interest prevents oil production cutback

Managing Partner / Spotlight Group
United Kingdom
  • If Russia sought to stabilise the oil price, it failed
  • WTI March 2016 closed on February 2 below $30 a barrel 
  • The oil market may be competitive but Saudi Arabia is the dominant force 
  • High output is squeezing weaker producers, so there's no production cut on horizon

By Stephen Pope

Last week the oil price staged a mini rally when the Russian energy minister, Alexander Novak, began a rumour that Russia would be entering into discussions with Opec. These would focus on a joint reduction in oil production as soon as February.

Does Russia want to stir up trouble in Opec and make life difficult for the Saudis? Photo: iStock

Novak said that the Kingdom of Saudi Arabia (KSA) had proposed a 5% production cut. This was quickly rejected by officials from KSA. Although the rebuttal comments were quickly reported on the wire of the Wall Street Journal it was too late to stop the price jumping by 2.85%, as shown in the chart below.
Source:, Spotlight Ideas

Russian rumours or Moscow maleficence?

Maleficence may be too harsh a way to describe the behaviour of the Moscow minister and yet one has to wonder why he would openly make such a claim, only for it to be swiftly denied by KSA. Is this Russia seeking to stir up trouble within Opec and make life difficult for the Saudis?

After all, the Russian economy is under extreme stress and the government has had to rewrite the budget at least twice as the price of oil has steadily fallen since the end of June 2014. Novak said a proposed 5% cut had been previously floated by Algeria and Venezuela, but  now he said the Saudis and their Persian Gulf allies…

 "…are ready to cooperate with others to bring stability to international oil markets …”

Immediately, Iraq’s oil minister came out in support of any production cuts, but perhaps the Saudis found an unlikely ally as Iran issued a statement confirming it would not commit to reduce production, regardless of promised non-Opec cooperation.

That stance from Iran cannot be a surprise as it has only just secured legal access to release its crude production onto the world market. The Iranians would hardly be prepared to relinquish much needed oil income, albeit at lower prices, after so many years of official market exclusion.

Iran is in no position to consider production cuts as it urgently needs new customers for its own oil. That said, the Iranians would not object to other Opec producers reducing their output in order to create some space for its oil. Well, that is just not going to happen.

Market manipulation or masking a mess?

What did Russia think it was going to gain from spreading this rumour? Even if one is generous to the Russians and consider that KSA initiated such a proposal, it was never going to be openly admitted.

The Saudis may just be starting to see their “flood the market” strategy paying off, as the low prices have certainly forced the closure of many oil rigs in both the US and Canada.
Baker Hughes
Source: Baker Hughes

The Russian economy shrank 3.8% year on year in the fourth quarter of 2015, following a 4.1% contraction in the previous period. It is the worst performance since 2009, as western sanctions and lower oil prices hurt external trade and public revenues. In 2015, overall GDP contracted 3.7%, according to figures from the Federal Statistics Service.

The impact of the low oil price has already forced Russia’s government to cut back high-profile projects such as the space program. Now, in a bid to raise much needed capital, the economy minister, Alexey Ulyukaev, is considering selling its stakes in both Sberbank (50% + 1 share) and VTB (60.9%) and use the raised capital to shore up other parts of the domestic banking system.

In Russia the total value of delinquent loans, while levelling off over the past month or two, has increased 60% over the past year to RUB1.6 trillion. Data from the Central Bank of the Russian Federation shows that there is no single sector that hasn’t seen the balance of bad loans increase. Given the economy is in the grip of a broad based recession, the pace of increase differs rather dramatically.

The worst increase in delinquent debt is found in the construction sector, with a gain in both the total amount of delinquent loans and the percentage share. Since the beginning of 2014, construction’s share of the total has more than doubled, going from less than 10% to more than 20%. No other sector shows a performance that is anywhere close to being this dismal.

Increased privatisation of state assets has been on the agenda for at least six months as the economy has struggled amid western sanctions and lower commodity prices. It is a policy that reportedly has the approval of President Putin, who knows that even he cannot mask the cracks that are appearing in the economy. The budget deficit is standing at 2.6% of GDP, not terribly high, but the currency is collapsing and the bite of sanctions and weak commodity prices is simply piling on the pressure. This means that Russia will have to make a cutback of a further 10% to the state budget.

Prime Minister Dmitry Medvedev said in Moscow on January 13:

“…We need to prepare for the worst scenario …We need to live according to our means, including by reducing budget expenditures, decreasing spending on the state apparatus, the privatisation of part of state assets. ..”

Saudi self-interest

KSA has become wary of forging agreements with Moscow as Russia has made promises to Opec several times over the past 15 years. Each time it has reneged and blatantly failed to follow through on the pledge.

What is at stake is a play to seize and control as much market share as is possible, and at the moment it is the Saudis who have the upper hand in being a sales maximiser by achieving the highest possible sales volume, without making a loss. In the chart below, to the right of point Q, the firm will make a loss, and to the left of Q sales are not maximised.
Sales Max

By following this strategy KSA is building for itself an increase in monopoly power which may enable the oil producer to put up prices and make more profit in the long run. Certainly, as rigs have closed in North America it is clear that the pursuit of predatory pricing has led to a significant reduction of rival supplies.

The Saudis are willing to sacrifice profits in the short term to increase profits in the long run. That would appear to be their plan as the International Monetary Fund is suggesting that the Saudi royal family are having to consider cutting back their luxury lifestyle and the kingdom may actually need to consider imposing taxes and reduce its generous electricity, water and oil subsidies for citizens.

Clearly the low oil price is not doing any producer a favour, but Saudi Arabia is in a far stronger position than any other nation to cope with the present price predicament.

– Edited by Susan McDonald

Stephen Pope is managing partner at Spotlight Ideas. Follow Stephen or post your comment below to engage with Saxo Bank's social trading platform.

marran marran
Very Very interesting article Stephen an education in the world of oil politics and not just from a trading point of view. But would it be fair to say we are going to be selling into rally's for a while yet?
Stephen Pope Stephen Pope
Hi Marran,
The oil market certainly feels as though it will hesitate on going lower as we press nearer 25...however, there is nothing magical about that level.

Financial press carries articles calling for 15 or even 10 dollars per barrel. For me...each press lower now is becoming increasingly tired.

Being short sub 30 dollars feels like holding a hot potato...nick a small profit and pass that short position on.

So I am keeping out fir a moment...maybe sell again mid 32 to 33...but stop at 35.

ozy ozy
Hi Steve.. I'm agree with you what you think Saudi's plan, but that scenario might be oil prices till 30, not down. when oil prices went under 30, they're out of their plans and they've got disturbed so much of that. that's why one official from them told "prices are unrational under 30" in Davos. This time they saw there is a big risk price could go under 30, even till 20... and that's why they need to move, a real move. I belive they will do a emergency meeting this month, with non-opec. russia says very open, they're ready joint a meeting. this time it's not a choose, it's an obbligation I think. we'll see. I have long positions and I hope prices go up.
ozy ozy
Steve, can I ask you a question. on my saxo's virtual trading, for trying (not real one I trade on saxo) :20 January I bought 3 different lots long: WTI apr. 2016 @29.98... WTI dec. 2016 @35.07...WTI dec. 2017 @38.53..... now, all them profit, but less profit have apr. 2016, only 32.01 price level, while others 39,25 and 43.00... I think it's better to buy 2017 futures.. what do you think to buy from now these days dec. 2017. does it logical? also i think till that time every month they don't add contango.
Stephen Pope Stephen Pope
Firstly Ozy I looked at the market re your costs on Jan 20 and the levels as at 13:45 GMT

APR 16 Jan 20th 29.98 Feb 3rd 32.09 + 2.11 + 7.04%
DEC 16 Jan 20th 35.07 Feb 3rd 39.36 + 4.29 +12.23%
DEC 17 Jan 20th 38.53 Feb 3rd 43.05 +4.52 11.73%

Bit look at the volumes today APR 16 28688, DEC 16 4347 and DEC 17 1577

The further out one travels the thinner the volume and so the more prone the price to exaggerated swings. This is a typical contango situation i.e. long future price is greater than the near future price.

Contango is the normal term-structure for a non-perishable commodity that has a positive cost of carry. Such costs include warehouse charges or interest forgone on money tied up less any income attained from leasing out the commodity if possible.

When you are buying your contracts, what margin are you paying, that can be crucial as one can see the Dec 2017 gain sine Jan 20 is 0.5% lower than Dec 16.
ozy ozy
Thanks Steve.. it looks more logical to buy dec.16 then.. better than near contract anyway, I think. dec. 16 and mar.16 difference is now near $9, but till dec.16 about 10 times next month contracts expires and jumps near $1 more every month. so, for example if any change of oil price till dec.16, anyway because of every month next contract renew price will go naturally because of contango. so, today WTI is 30, dec 16 will be 40 without any move of real price.. I'm confused to understand that. I don't know if I'm wrong to think that. anyway what do you think it's better to buy for long term dec 16? thanks Steve.
Stephen Pope Stephen Pope
I think Dec 16 is far enough ahead.
ozy ozy
if I want a long-term position for long on WTI, do you think that dec. 16 is better, or just buying next month's future and make every month roll-over?
ozy ozy
Steve, also I wanna add something else here, what I think about an Opec move. please tell me if I'm thinking wrong: So, there is around a 10million bpd production for saudi and if they agree to cut %5, just 500k less and 9,5million they continue.. but, price will move up a lot..may be double till june... So, 10million bpd X $30 is $30million revenue a day..... but with a cut %5, price move up to $60: 9,5million bpd X $60 is 57million revenue per day.... the question is: if saudi doesn't accept a meeting with russia and don't do production cut, what's the reason?? only thing, it can be a dirty game on Russia from opec, supported by US.. it's a side war, the war is in mideast, on syria about sharing a big mideast's petrol cake. they want to get out russia from mideast. to do that they need to try worsen russian domestic economy and less powerfull...If Saudis decide to do an called emergency meeting to cut production by russia,, I will not have any doubt about this thinking.
Stephen Pope Stephen Pope
The lower volume of longer dated contracts has two implications

1. Less liquidity 2. Greater volatility as a few trades have greater leverage on the price.

Also given the contango your margin deposit will be greater.

I prefer to play with the front month and roll if I am staying in the trade.


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