U.A.E.’s Exit Does Not Mean The End Of OPEC

BERLIN, GERMANY – APRIL 17: Suhail Mohamed Faraj Al Mazrouei, Minister of Energy and Industry, United Arab Emirates speaks during the ‘Berlin Energy Transition Dialogue’ on April 17, 2018 in Berlin, Germany. (Photo by Janine Schmitz/Photothek via Getty Images)

Photothek via Getty Images

Does the exit of the U.A.E. from OPEC signal a major change in the organization and its impact on oil markets? Many feel that it could, either as other nations decide that they, too, should exit the organization or that a price war will develop in retaliation to the move. Either could mean the group’s influence wanes or it even dissolves.

Of course, rumors of OPEC’s death have been greatly exaggerated, as Mark Twain once said. The organization is inactive or irrelevant for lengthy periods when the market is in balance or, less often, when the group has no spare capacity to raise production. Like dieters who are successful when there is no ice cream in the house, members don’t cheat on quotas when they have no extra capacity available.

And when the price collapses, as in 1986, 1998, 2014 and 2020, some thought that the group has failed as so many others before them. Yet each time it has risen Phoenix-like to re-establish something close to their desired price, although often at lower than the pre-collapse level.

Obviously, past exits from the group such as by Indonesia or Ecuador (twice) did not raise concerns; the first became a net importer, the latter was never a major exporter. Other countries, most notably Iraq in the late 1980s, Venezuela in the 1990s and Iraq again now, have violated their quotas but didn’t discuss leaving the organization: if the co-op doesn’t make you pay your dues, there’s no incentive to quit.

But the U.A.E. case is somewhat different. It is a major oil producer and exporter, with a pre-war supply of 3.5 million barrels a day (mb/d) and capacity at 4.3 mb/d, it dwarfs the non-Gulf members by a factor of two or more. It also has the ability and intent to add more than another 1 mb/d of capacity and production by 2027, which is more than any other producer could accomplish.

That amount of new supply in one year would have a significant market impact, exclusive of the Iran War effects. Before the war, global production was thought to be 2 mb/d or more above demand, with most of the surplus being absorbed by China for its strategic reserves or accumulating in floating storage because U.S. sanctions made it difficult to sell.

When the Iran war ends, production will presumably be restored in the Gulf area, albeit after a few months, and there is little reason to believe it will be lower than the pre-war level. Given current economic uncertainty, the implication is that the market will again move into surplus. If sanctions on Iran are ended, the surplus will be slightly boosted. Adding 1-1.5 mb/d additional U.A.E. supply and possible economic and/or demand weakness will mean a notable surplus. If Iran sanctions end, then the amount of oil which is locked away in floating storage will not increase as last year.

At the very least, it seems likely that by the end of next year at the latest, the world market will be in serious surplus and prices will be under threat. At that point, the remaining members of OPEC will either have to reduce quotas again or let the price drop. Given political tensions between Saudi Arabia and the Emirates, the likelihood that the Saudis would unilaterally cut production to support the price, as they have sometimes done in the past, seems small.

The most likely scenario would be for major price weakness and pressure on the Emirates to reduce production, possibly to a higher level than pre-war but significantly below the 5 mb/d they have been suggesting as a target. Granted, the U.A.E. has massive financial reserves and could survive a lengthy downturn in oil prices; their ability to resist political pressure from all of their neighbors might be more problematic.

But economics might prove the more compelling argument for them to either rejoin OPEC or at least become a de factor member of OPEC+, accepting a new quota even if informally. The strength of OPEC has come from its ability to deliver higher oil prices to its members even if that requires they sometimes reduce production. In the past several decades, it is rare for quotas to require a reduction of more than 10% of production, which in the case of price collapses like 1998 have delivered a price improvement of 50% and more. That is the compelling logic behind the organization’s success and it will likely hold true if a new price war breaks out.

As the Iran War ends and the global economy recovers, the pre-war price of $65-70/barrel might well prove to be unsustainable, especially if the U.A.E., Iraq and Venezuela are all raising production. However, that will not be apparent until global inventories are rebuilt and the demand situation clarifies. Before that, the status of the U.A.E. and its willingness to ignore pressure to rein in production could see some sharp price swings.