Saudi Arabia's oil policy, shaped by multiple factors including domestic fiscal-geopolitical objectives, Organization of Petroleum Exporting Countries dynamics, and market conditions, has been constantly changing.
With limited policy tools, the kingdom always faces a trade-off between market share and oil revenue maximization when it comes to its oil output policy. However, when Saudi was no doubt a "swing producer," its oil policy was largely predictable.
From 2014 onwards, as US shale introduced a new set of uncertainties, Saudi's policy became relatively opaque, as the country, like the rest of the world, has limited information about price elasticity of shale oil.
During the steep decline of oil prices since June 2014, Saudi's policy shifted from market share strategy in November 2014 to production cut agreement in November 2016. Despite increased uncertainties, these policy options were still rooted in basic cost-benefit logics.
Bassam Fattouh, director of the Oxford Institute for Energy Studies, raised explanations of Saudi's policy from the game theory perspective, which are more or less different from beliefs of "price wars" or "conspiracy theories."
Why not cut?
In the end of 2014, the industry did post hope that Saudi and OPEC could cut output to reverse the price fall. However, a couple of factors shaped Saudi's decision in favor of market share strategy, Bassam said.
The market imbalance was very large, which meant that Saudi would have had to make a big cut to balance the market. Saudi will not cut unilaterally, shaped by the mid-1980s events when its attempt to protect price resulted in a large loss of market share without actually increasing price.
There was also difficulty reaching an agreement within OPEC and with non-OPEC producers as the pain of lower oil revenues was not widely felt. Many OPEC countries had ambitious plans to increase capacity.
Meanwhile, strong fiscal buffers built during the boom years made Saudi believe that it could withstand lower oil prices for longer.
Heightened uncertainty about US shale response was also important. "Under uncertainty about US shale response, Saudi Arabia is better off to assume that shale supply is elastic and not to cut production," Bassam said.
Why cut?
In November 2016, OPEC ended the market share strategy and pursued an agreement to cut output. According to Bassam, the shift primarily occurred because the cost of pursuing market share exceeded the benefits.
Exporting countries including Saudi have been hit hard by low oil prices. The increase in output does not compensate for the decline in oil price and hence oil revenues fall. As an oil-dependent economy, Saudi's fiscal buffers eroded quickly.
"After sharp decline in non-OPEC output, the pace of decline would have slowed down as players adjust to lower price environment and hence the marginal benefits from maintaining market share are small," he said.
Meanwhile, although non-OPEC supply and that of some key OPEC countries fell sharply, supply continued to increase in other key producing countries. Also, projects sanctioned in the period of high oil prices started coming online.
The timing of the cut matters too. "Although OPEC needs to test US shale response on the upside, the market is already rebalancing so the benefit of cut is positive and the cost of obtaining information about shale response on the upside is low," Bassam noted.
What next?
In 2017, OPEC behavior will again be the key factor shaping market dynamics. Potential scenarios would largely depend on the response of US shale and the adherence to the agreement.
Bassam points to three scenarios: (1) If there is no adherence to the agreement by other countries, Saudi will likely increase output; (2) If US shale response is big and fast and substitutes for OPEC output cut, Saudi is most likely to shift back to increasing production, as output cut would result in loss of market share, without any durable impact on prices, and hence lower revenues; (3) If US shale response is moderate and does not substitute for output cut, then the most likely outcome is extension of the agreement, which can help put a floor on the oil price, accelerate withdrawal of stocks, and shift the curve into backwardation.