Why Saudi Arabia won't cut oil production

Will OPEC blink?
Will OPEC blink?

Nine months after OPEC decided to leave its production target unchanged and pursue market share instead of trying to prop up prices, the group is facing a set of complex problems and decisions going forward.

At first blush, the collapse of oil prices and the resiliency of U.S. shale appears to hand OPEC, and its most powerful member in Saudi Arabia, a stinging defeat. U.S. oil production has leveled off but has not dramatically declined. The revenues of OPEC members have fallen precipitously along with the price of crude.

Saudi Arabia is under tremendous pressure. The Saudi government is considering slashing spending by a staggering 10% as it seeks to stop the budget deficit from growing any bigger. The IMF predicts that Saudi Arabia could run a budget deficit that amounts to about 20% of GDP.

Related: How To Profit From Crashing Oil Markets

The pain is manifesting itself in different ways. Not only will the Kingdom have to cut spending, but it has also turned to the bond markets in a big way. Low oil prices have forced Saudi Arabia to issue bonds with maturities over 12 months for the first time in eight years, raising 35 billion riyals (around $10 billion) so far in 2015.

At the same time, the currency is coming under increasing pressure. Saudi Arabia pegs the riyal to the dollar at a rate of about 3.75:1, but speculation is rising that the currency may need to be devalued, given that the oil producer won't be able to defend that ratio indefinitely. On one-year forward markets, the riyal has already weakened to 3.79, according to the FT. That forced the government to issue a statement, saying that the Saudi Arabian Monetary Agency "is committed to the policy of pegging the Saudi riyal with the American dollar." But if oil prices do not rebound, the government will have to continue to draw down on its foreign exchange in order to keep the currency steady.

Related: Mining Hedge Funds Just Bought These Copper Deposits... Cheap

All the damage inflicted upon Saudi Arabia has the world looking back towards Riyadh, especially after oil prices crashed on "Meltdown Monday." The markets are trying to figure out if Saudi Arabia may switch tactics in order to stop the crash from worsening.

Saudi Arabia oil minister
Saudi Arabia's Oil Minister Ali al-Naimi (center) attends the opening of the Ministerial Conference of the Organisation of Arab Petroleum Exporting Countries (OAPEC) in Doha on December 21, 2013.

Pressure is actually the greatest within the oil cartel. Algeria's oil minister wrote a letter to OPEC's secretariat requesting action, although the letter stopped short of a call for a production cut. Months earlier, before OPEC's last meeting in June, Venezuelan officials pressed for a change in strategy to shore up oil prices. Venezuela is arguably the worst off member, as its economic and financial crisis worsens by the day.

More recently, Iran's oil minister said that his country would increase oil production "at any cost," but also supported an emergency OPEC meeting before the scheduled summit in December in order to discuss the group's strategy. More and more members are clamoring for a cutback in the cartel's production.

If Saudi Arabia's strategy of pursuing market share has not worked, and even its colleagues inside OPEC want a policy change, perhaps Riyadh would reconsider and now decide to restrict production in order to boost prices?

Related: Why oil prices could drop to $15 a barrel

That is more wishful thinking than a likely possibility. There is little chance that Riyadh would retreat now just as the worst pain is really beginning to set in for rival producers. Sure, Saudi Arabia is suffering from low prices, but its competitors are hurting worse. U.S. oil production, after years of blistering growth, has not only ground to a halt, but has started to decline. Output peaked in March at 9.69 million barrels per day (mb/d), dropping to 9.51 mb/d in May (the latest month for which accurate data is available). In all likelihood, the decline has picked up pace in the intervening months.

And more to the point, U.S. oil production will continue to decline the longer Saudi Arabia holds out. Several companies have already gone bankrupt, and more are no doubt coming down the pike. That will allow Saudi Arabia to achieve its goal of holding onto market share, and letting prices adjust on the back of rival producers.

To highlight this point, Saudi Arabia's decision to cut its budget should be seen not as evidence that it is buckling under crushing weight of low prices, but that it is in the game for the long haul. It is shrinking its budget to fit a world of depressed oil prices, positioning itself to ride the wave as far as it goes. Cutting spending is actually a signal of the government's resolve in regards to its current oil strategy, not a sign of wavering.

Nick Cunningham is a journalist for Oilprice.com

CNNMoney Sponsors