OPEC: Deal, Under Stress, but Intact

Published on November 28, 2016
SGH Insight
We still believe an OPEC agreement for up to 1 million barrels per day in total announced production cuts — built around firm output cuts of as much as 800,000 bpd by Saudi Arabia, Kuwait, and the United Arab Emirates — and supported by the cooperation of Russia in freezing its current output, is, on balance, still more likely than not at the Summit in Vienna this week.
Market Validation
(Bloomberg 12/1/16) Oil traded above $50 and crude producers rose after OPEC approved its first supply cuts in eight years, with the focus now shifting to how strictly the group will implement the deal. Futures advanced 2.6 percent in New York. Prices surged 9.3 percent Wednesday, the largest gain since February amid record volumes. OPEC agreed to reduce collective production by 1.2 million barrels a day to 32.5 million and Russia pledged a cut of 300,000.

The crude oil market has been whipsawed by a flurry of contrasting headlines and misinterpreted or just plain badly reported news stories in recent days, and indeed, as OPEC’s high stakes Summit meeting draws near, the positioning and posturing of the key oil powers may only intensify in the coming two days.

The details are still in play at this point in the negotiations — this is OPEC after all — and in some sense there is nothing until there is everything. But for now, we would stress two key takeaways:

*** First, we still believe an OPEC agreement for up to 1 million barrels per day in total announced production cuts — built around firm output cuts of as much as 800,000 bpd by Saudi Arabia, Kuwait, and the United Arab Emirates — and supported by the cooperation of Russia in freezing its current output, is, on balance, still more likely than not at the Summit in Vienna this week. ***

*** But second, we would also caution it is by all means not a done deal yet, and it could still fail at the eleventh hour due, namely, to the ongoing, bitter rivalry between Saudi Arabia and Iran. We do think the probabilities are low, albeit higher than they were a few days ago in that the differences have nothing to do with barrels, but which side is making public concessions to the other. ***

Saudi Concessions – and Leverage

The Saudis have privately given in to Iran on the principle of a “partial” exemption to new OPEC quotas and apportioned output cuts until it reaches pre-sanction levels, but the question remains at what level: the Iranians are brooking no compromise below 4.2 million bpd while the Saudis are insisting on 3.8 million bpd.

We believe the Riyadh will concede to the higher output figure demanded by Tehran — the Iranians lack the capacity to go any higher any time soon in any case — but the Saudis will condition it on a public agreement by the Iranians to freeze their output at the pre-sanction levels and to agree to the principle of a hard quota and potential cut at the June OPEC meeting.

The ongoing OPEC meetings have been boosted by reports that the Iraqis, who had wanted a total exemption in production cuts, are now willing to consider a production freeze at 4.54 million bpd with the probability of a nominal cut.

Senior Saudi officials see the OPEC agreement as a two step process, with June next year, not November this year, as the pivotal, watershed meeting. By then, Iran must fully participate in the output cuts like the rest of OPEC, perhaps by then even including Nigeria and Libya. But the key bet is rising global demand that may do as much or more to rebalance the oil markets.

And if the Iranians, or the rest of OPEC for that matter, are failing to abide to the agreement reached in Vienna this week, the Kingdom will make clear its intention to return to its maximum market share strategy by ramping up the spare capacity it asserts amounts to as much as 2.5 million bpd, with the prices left to settle where the market dictates.

Russian Participation, Clarifying al-Falih

One additional point of widely reported risk to the OPEC agreement has been whether the Russians will agree to production cuts. That is highly unlikely, but more importantly, in the talks between Riyadh and Moscow, the Russians were never asked nor expected to cut output, but only to freeze current record levels in the near term and to maintain supportive public rhetoric, which they have.

That the Russians are “cutting” by not increasing by the planned 300,000 bpd next year is a stretch of the meaning of a cut by anyone’s definition, but it is the necessary sort of public rhetoric that meets the Saudi conditions for their own major output cuts in November.

That understanding between the Saudi and Russian oil officials is the main reason the Saudis said they would not bother to attend the technical working group’s planned meeting between OPEC and non-OPEC officials today. The meeting was subsequently canceled and is now a purely OPEC meeting.

But the press got off track in ominously reporting the Saudi no-show to the planned technical level meeting planned for this Monday with the Russian oil officials as an indication of the Saudis cooling on an output agreement, which they were and are not.

The original meeting with the Russian oil officials was premised on OPEC coming to an agreement among its 14 members, which would then be laid out to the Russians to win their agreement to participate in the efforts to shrink the oil supply glut.

But OPEC failed to conclude its internal agreement, and without it, Saudi officials felt there was nothing to talk about or to offer to the Russians. Worse, the rest of OPEC would no doubt shift from the demands on their own production cuts to demanding cuts from the Russians and the other key non OPEC oil producers or still more from the Kingdom. So that meeting was a non-starter, but it was not in anyway a new hardening of the Saudi position.

The meeting today, on the other hand, is again an internal OPEC technical committee meeting, and the Saudis are more than happy to participate, if anything else, to gauge whether the other member states are abiding by their terms, and in particular, if the Iranians are coming round.

Another narrative running astray of the actual thrust of the negotiations is the reported remarks by Saudi oil minister Khaled al-Falih’s over the weekend to the Saudi newspaper Asharq al-Awsat asserting that production cuts were not the only path to rebalancing the oil market. For one, the remarks were mostly meant for domestic consumption and were intended to pre-position a domestic audience for the contours of the deal, and to brace for any setback or failure to stabilize oil prices.

Second, al-Falih was also not inferring any Saudi back pedaling from its own output cuts, but that the final, completed deal may embrace both cuts and freezes in output.

And finally, when he said he believes an impending OPEC agreement will only be bringing forward the market rebalancing that will come next year with or without OPEC cuts, he was pre-positioning the messaging from Saudi oil officials if a deal does indeed fall through.

But he was not in either of the reported remarks backing away from the Saudi determination to construct a viable, credible oil output agreement in Vienna.

The Iranian Factor

The problem, as seen by Riyadh, is for now the Iranians are not giving the Saudis, and Deputy Crown Prince Mohammed in particular, even a bare minimum of public concessions or much in the way of rhetorical support to the deal.

Worse, perhaps reflecting internal disputes between the moderate economic leadership under Iran’s President Hassan Rouhani and the hardline Iranian Revolutionary Guard, a senior Iranian naval commander boasted to the Iranian press agency over the weekend that Iran will soon be expanding its naval presence with naval bases in both Syria and Yemen.

Aside from the fact the Iranian-allied Houthis lack control of any naval or major port facilities in Yemen – Aden is firmly in the control of the Saudi-backed Yemeni forces — to tout an Iranian military presence in Yemen when the Saudis are already dealing with a major debacle in its military campaign there is nothing short of highly inflammatory.

It could even threaten to derail the Vienna agreement at the worst possible moment.

We could not understate how much political pressure Deputy Crown Prince Mohammed bin Salman is under, with the major setbacks in both Syria and Yemen, and the first signs of public resistance to the budget cuts and the disruptive ambitions of the Saudi Vision plans to transform the Saudi economy.

A key cornerstone to stabilizing the budget and the economy, as well as the planned Saudi Aramco IPO or future sovereign bond issues, and above all the political standing of the Deputy Crown Prince himself, is stable oil prices. And for that reason alone, if anything else, Riyadh badly wants the deal it has been laboriously constructing these last few months and which it expects to complete by the time of the June OPEC meeting next year.

But at the same time, neither the young Deputy Crown Prince nor the senior Princes of the Al Saud will sign off on a deal in Vienna at the price of swallowing national pride to bring the Iranians on board. That is why while we think on balance an oil output agreement in Vienna is more likely than not, it is by no means assured.

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