Oil: Another Step Towards Output Deal

Published on February 16, 2016

The single most important takeaway in this morning’s news from Doha that Saudi Arabia and Russia have agreed to a provisional oil output “freeze” is that both countries have come out of their corners to negotiate directly on what we continue to believe will be an eventual collective cut in oil output among the OPEC and non-OPEC countries.

*** In other words, this is not the endgame to the “deal” and it can hardly be a surprise the oil markets would react skeptically to the announcement of an output “freeze” — at already very high output levels and only if other oil producers join, so how hard can a freeze be? But the freeze is nevertheless the most important milestone yet in the long process of “trust building” (see SGH 1/29/16, “Saudi Arabia: Building Towards Firmer Oil Prices”) which is an essential part of a credible oil output agreement falling into place to bring supply and demand into balance and stabilize oil prices. ***

*** Assuming the major producers are seen to be abiding by the freeze in production, it will bring the output levels into maintenance periods across the oil producing countries that will marginally reduce supply, and only then, if commitments are being met, will the “trust-building” lead a final push for coordinated output cuts going into what Saudi officials believe will be a tightening oil market. A production cut by the Kingdom and its Gulf allies of around 800,000 barrels per day could be on offer, but the other OPEC and non-OPEC oil producers could cut as well, especially Russia, or in case of Iran, manage the pace of its return to post-sanctions export levels to support if not abide at some point with a freeze. ***

A few quick points:

This long path to stabilize oil prices, it must be said, is fraught with obstacles, the least of which is the situation on the ground in Syria. And that is before negotiators even get to the usual OPEC agonies of quotas and market shares. But crucial is what we have been reporting since last month about a shift in the Saudi stance to seriously consider an output cut if the right terms can be put on the table (SGH 1/21/16, “Saudi Arabia: Lending a Hand”).

The weak link in the freeze — which is between Russia and Saudi Arabia, with the others oil producers free to “join” — is now clearly Iran in the near term, underscored by the arrival of Iranian crude to European markets for the first time in three years following the lifting of the international sanctions over Tehran’s nuclear program. It is our understanding that in any future oil output deal, Iran is likely to win an exemption on output cuts, but the terms are still to be worked out.

Bear in mind as well that while the new Iranian barrels into the global oil markets was obviously expected, behind the scenes there is an “understanding” that Tehran will phase its higher crude exports through the year to limit its dislocation of oil prices, an agreement that was informally advanced between Riyadh and Tehran during the visit in January by Chinese President Xi Jinping.

And when Iranian officials boldly vow a quick return to Iran’s old production levels and an increase of 500,000 bpd in short order and 1,000,000 bpd soon after, that should be seen as a negotiating stance and reminder to Saudi Arabia especially, who with Iraq has largely filled in the sanctions created output gap, of Iran’s “rightful” production levels, and not as an indication of any lack of willingness to cooperate in any and all efforts to stabilize prices from here.

Indeed despite Tehran’s quick efforts to elbow back into the European markets, Iranian officials are highly cognizant of the need to pace Iran’s return to markets, and so as we understand will look to phase in the sale of Iran’s enormous stockpiles of crude in floating and in onshore storage terminals over the course of the year, rather than all at once, even as it steps up its efforts to ramp up production.

And while there is certainly no sudden love lost between Riyadh and Tehran on the still highly explosive geopolitical front, business is business, and Saudi Arabia along with other producers fully understand the need to come up with a production solution that incorporates Iran’s “unique” post-sanctions situation if a deal is to be had.

In a related development, the official Saudi Press Agency issued a statement that “no date has been set yet” for a visit to Moscow by King Salman bin Abdul Aziz, a visit we first reported was in the works last week (SGH 2/11/16, “Oil: Edging Closer to a March Output Deal”).

The importance in how the statement was written is the absence of a denial on the impending visit first reported by Russian news agencies. And by “not yet” the Saudis are essentially confirming a visit is in the works, which we understand was set in motion when the King’s son, deputy Crown Prince Mohammed bin Salman went to Moscow last year.

The primary obstacle to announcing the King’s visit — and indeed an eventual oil agreement between the Kingdom and Russia — is still the situation in Syria. The Saudis will not announce anything like a major trip by the 80-plus year old King, much less to Moscow, when the Russian air force is pounding the encircled positions of Saudi-backed rebel in and around Aleppo, including the alleged bombing of a hospital.

But while analysts who by and large have missed the turn in negotiations have been quick to dismiss today’s deal, we were frankly surprised the freeze agreement in Doha got as far as it did.

The US and Russia are currently working out the “modalities” of bringing the current truce in Syria to a genuine cease-fire by a deadline this Friday, without which, the probabilities of both a King’s visit and a durable oil output deal will drop significantly.

It is our sense the cease-fire will need to come into effect by or close to its Friday deadline for the movement on an oil deal to stay on track. The next 72 hours are going to be critical.

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