Oil: An Output Deal and the Riyadh-Moscow Axis

Published on February 19, 2016

In light of the slow but steady “trust-building” movement towards an OPEC non-OPEC oil output agreement, and the faster moving developments on the ground in Syria and diminishing near term prospects for the Munich-brokered “cease-fire,” two key points are warranted this morning.

*** A meeting next month in Vienna will be convened among OPEC technical experts, which will carry elevated importance in the immediate wake of the recent oil output “freeze” agreement between Saudi Arabia and Russia, and which will be joined by the other OPEC and perhaps some non-OPEC oil producers like Mexico as well. We believe this will be one more step in what we have termed the “trust-building” path towards an eventual oil output cut by OPEC and key non-OPEC oil producers, probably coming into sharper view by the early summer and second half of this year. ***

*** We would take note of the call by Russian President Vladimir Putin to Saudi King Salman bin Abdul Aziz al-Saud earlier today as underscoring the importance of an impending visit by the King to Moscow. The date has yet to be confirmed by Riyadh, but a larger strategic shift is underway in relations between Russia and Saudi Arabia that will ultimately determine the fate of Syrian President Bashar al-Assad and an end to the Syrian civil war and, crucially for the markets, the whether, when, and if so final terms of an OPEC/non-OPEC oil output deal. ***

The “Trust-Building” Timeline

Recent remarks by Russian and Saudi officials about the freeze agreement should be seen as a near term positioning in the ongoing negotiations, whether it is conflicting Russian assertions whether a participation in the freeze can be “enforced” (of course it can) or that Saudi Arabia is refusing an output cut (of course it is, now, but it might later if the others show discipline).

Probably the most important takeaway from the public remarks is the assertion by the Russians that Iran does not necessarily have to participate in the freeze; as we have been reporting (SGH 2/16/16, “Oil: Another Step Towards Output Deal”), Iran is not really expected to anyway, and is essentially being granted an exemption until new quotas are set by OPEC.

Again, all the public remarks are both positioning and as much as possible, to keep a lean in market sentiments towards higher oil prices as a bridge until oil producers get into the maintenance period next month, in which some 3 to 3.5 million barrels per day of crude exports will be temporarily coming off the market. In addition, a shift in Saudi Arabia’s crude oil production from exports to meet domestic demand for crude to power the summer surge in domestic electricity demand will in effect translate into a 300,000 plus cut in the Kingdom’s crude supply to global markets.

The output freeze, so quickly dismissed by oil market analysts, was never intended to have much of a real near term effect beyond the sentiment campaign. But where the freeze will come into play is later when the producers’ discipline will be tested by, say the summer, when Saudi and other OPEC officials believe the oil market will be tightening with rising global demand, premised on continued US growth and the absence of a “hard landing” in China.

If OPEC and Russian discipline holds against the temptation of increasing output into higher demand, a deal to seal a new, higher equilibrium in crude oil prices, of at least $45, is likely to be struck with output cuts led by Saudi Arabia, its Gulf allies, and Russia leading the way, probably now by late summer unless there are truly impressive diplomatic breakthroughs or changes in the supply and demand balance in the oil market.

March then, is not so much when an oil output agreement will be reached, but the start to the “trust-building” process we have been describing (see, for instance, SGH 1/29/16, “Saudi Arabia: Building Towards Firmer Oil Prices”) to get a floor under oil prices until there is the expected tightening in the crude oil market.

The first step, then, to draining the supply glut that most estimate at around 1 to 1.5 million bpd would be through the lower oil exports — due to the temporary maintenance declines and the Saudi shift of its now frozen output to domestic demand in the coming months — going into a rising demand. The subsequent output deal, if it comes about — and we think it will when the two major oil powers, Saudi Arabia and Russia, are both determined to clinch one — could in effect by then mark a seal on a new oil price equilibrium rather than drive prices that much higher.

In other words, a policy to “drain the glut” between now and probably into the third quarter of this year is the underlying driver to what we have been describing as a critical but fundamental shift in the Saudi oil policy (see SGH 1/15/15, “Saudi Arabia: Riyadh’s Strategic Gambit”). OPEC management of oil supply to protect revenues for its members can no longer work as it did in the previous era of Saudi Arabia’s ability to swing its production by millions of barrels a day to balance supply and demand. OPEC, Riyadh believes, will never be able to announce a meeting, fly into Vienna, and cut a high profile deal on new quotas to instantly swing prices.

Instead, Riyadh sees the critical need for this sequence of incremental trust-building steps as the only possible way to build a credible output agreement after the lessons learned of repeated slippage and outright cheating by many oil producers in the wake of previous attempts at oil supply agreements, with Russia being the most blatant culprit in ignoring its commitments.

The Riyadh-Moscow Negotiations

On that note, it is important to frame the entire arc of this long negotiation process, and indeed, the fast moving developments on the ground in Syria and the dimming prospects for last week’s Munich-brokered cease-fire coming into place later today or within days, within a rapidly evolving strategic relationship between Saudi Arabia and Russia.

A glimpse of that movement in relations came earlier this morning in reports by both the Russian and Saudi official media of a call by Russian President Putin to Saudi King Salman. That call follows the premature announcement by the Russian media last week of a visit to Moscow by King Salman that is being still negotiated for this March, later toned down today to an offer to meet “when convenient” in the absence of a firm confirmation of a date by Riyadh.

The visit has in fact been in the works ever since the discussions in Moscow between Putin and the King’s son and Deputy Crown Prince Mohammed bin Salman last year. As further enticement the Saudis have also been dangling potential investments of $10 billion or more in the Russian energy sector.

We understand the Saudis are seeking to make the Salman visit into something akin to a “Nixon to China” message from Washington to Moscow; that Riyadh has both strategic and economic options, be it Russia or China. On the other side of the diplomatic maneuvering is Moscow’s keen desire to deepen its relations with Saudi Arabia as a linchpin to further expanding its regional influence at the expense of the US, whose uncertain policies in recent years has created a power vacuum in the region. A breakthrough with Riyadh would crown the re-entry of Russia as a key powerbroker in the region after more than 40 years since its advisors were expelled from Egypt under former President Anwar Sadat in 1972.

But the jockeying for position between the two powers is still fraught with difficulties that require a delicate balance of conflicting interests and high profile positioning in the region, above all, in the hugely complicated civil war in Syria, the fate of Syrian President Bashar al-Assad, and Saudi Arabia’s new Sunni ally Turkey and its dealings with the Syrian Kurds.

Russia’s Strategic Gains in Syria

To be sure, Moscow has gained significant leverage in its negotiations with Riyadh through its large-scale commitment of military resources to Syria, in closely coordinated air and logistical support of the Syrian army and its Hezbollah and Iranian Revolutionary Guard allies,

The revitalized Syrian Arab Army’s 103rd brigade of the Republican Guard have in recent weeks of intense fighting driven Jabhat al-Nusra and its Islamist allies out of the Latakia mountains in the northwestern corner of Syria that is largely populated by Syrian Alawites, and are driving into al-Nusra’s Idlib province stronghold. Syria’s so-called “Tiger Forces” consisting of a “desert hawks” brigade and Hezbollah and Iranian fighters, and supplied with advanced Russian T-90 tanks, have successfully encircled most of the remaining Saudi and Turkish-supported rebel fighters around Aleppo by cutting off their supply lines into Turkey. The Syrian 104th brigade is even pushing towards the ISIS strongholds in Raqqa.

Adding to the complications and driving something of a wedge between Saudi Arabia, the US, and Turkey, is the success of the Russian-backed Kurdish People’s Protection Units, or YPG in expanding their control of a northwestern corner of Syria along the Turkish border. The Kurdish militias are threatening the Azaz “pocket” through which most of the Turkish arms and support has moved to the rebel forces in Aleppo.

It is this threat of the Russian-supported Kurdish YPG linking up to the US-supported Kurdish control of the entire stretch of northern Syria along the Turkish border that is the “red line” put down by Turkey, which is threatening a major escalation of the conflict, with its Second Army positioned on the Syrian border, mostly around Azaz border crossing.

Assad as an Oil Deal Card

But despite the strategic gains by Russia at the expense of Saudi Arabia, not to mention the US and an increasingly desperate Turkey to deter the Syrian Kurd advances, we understand that Riyadh is still hoping a deal can be struck with the Russians to support the removal of Assad from power in a negotiated end to the Syrian civil war.

The Russians are asserting there is no linkage between Syria and an oil deal, but there is nevertheless an explicit linkage in that it will be very difficult politically for the Saudis to proceed with the King’s visit without a cease-fire and the eventual movement back to the peace negotiations in Geneva on a post-Assad Syrian government. On the other hand, we also understand the Russians will not be willing to prop up Assad in the medium to longer term if oil prices remain low and there is no oil production cut, a cut that is not possible without the Saudis.

In other words, while no explicit link between the developments in Syria and an eventual oil output deal will ever be admitted by either Moscow or Riyadh, the fate of Assad and an eventual cease-fire are nevertheless crucial to a potentially far-reaching strategic realignment of the region that will likely rotate around the evolution of relations between the Kingdom and Russia, and what we believe will be an eventual oil output agreement by the second half of this year.

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