Oil: Output War

Published on April 19, 2016

For all the skepticism and angst over hedge fund longs going into last weekend’s Doha meeting, crude oil markets have displayed impressive resiliency in the days since despite the failure there to reach a production freeze accord. The market looks to be buoyed in part by the Kuwait oil workers strike, other small output setbacks, and an upbeat chatter of officials from oil producers still scrambling to keep a bullish sentiment to prices feeding into a new narrative that the market’s supply and demand balance may not be so bad after all.

*** It is our sense, however, once the initial volatility clears, that after rising since January on a wall of skepticism from $26 to $42 the fallout from the collapse of the Doha talks will now soon play out in capping the top side, with the level for a downside floor less certain, but a low to perhaps mid $40s a barrel (WTI) price ceiling we cited yesterday (SGH 4/18/16, “Oil: Doha Aftershocks”) looking that much more certain given the likelihood of new supply in the near term. ***

*** That prognosis is on two key fronts. First, we are taking seriously the less than veiled threat by Saudi Deputy Crown Prince Mohammed bin Salman to now rapidly ramp up Saudi oil output by as much as a million barrels per day to go head-to-head in competition with Iran for market share. The Kingdom can lift its production here and there, but we understand the additional output of up to 300,000 bpd from the neutral zone with Kuwait will be an important signal of Saudi intentions. ***

*** Second, another fallout of Doha, or more specifically of how the Saudis misplayed the negotiations, is how furious Russian energy ministry officials, led by Minister Alexander Novak, are said to be over the Saudi “betrayal” in Doha. We understand that Russia is now gearing up to ramp up oil exports where possible, to modify its energy sector tax policies, and at minimum, work to prevent the expected declines in output this year. ***

We also suspect the planned visit to Moscow by Saudi King Salman bin Abdul Aziz Al Saud, intended by Riyadh to cement a new balance of power in the volatile Mideast, is likely to be postponed, at least without a scramble of diplomatic finessing. And whether coincidental or causal, the Syrian peace negotiations in which Moscow and Riyadh are two of the pivotal outside powers also seem to suddenly be breaking down.

Supply and Demand Balance

The energy markets seem to be buoyed in large part by a new narrative underpinning a modest at most fall in crude oil prices of a better than previously understood supply and demand balance. At the top of the list of bullish supply shocks is the Kuwaiti oil workers strike, and the usual ongoing delays and difficulties in lifting exports on a consistent basis in trouble spots like Venezuela, Nigeria or Libya.

Between them, they are said to be more than enough to offset the political setback in Doha. The oil output freeze, after all, was always about Saudi/Russian moves to stoke a bullish sentiment of expectations until a tighter balance drove the market at some point later this fall rather than any actual removal of barrels from the market (SGH 2/19/16, “Oil: An Output Deal and the Riyadh-Moscow Axis”).

The Kuwaiti oil workers strike — two points to the Kuwaitis for even allowing a worker’s union — has now entered its third day, taking Kuwait production down by nearly half to reportedly no more than 1.5 million bpds. But we doubt the strike will last more than a few days, and the odds are overwhelmingly against it lasting weeks.

We understand in fact the Kuwaiti government was ready to sign-off on a settlement reversing the proposed cuts to pay and benefits to the energy sector workers at the heart of the strike, but that officials from the state-owned Kuwait Petroleum Corporation didn’t show up for the meeting. Talks are being rescheduled, but we seriously doubt KPC will be able to defy the government on the pay and benefits. That means those lost Kuwaiti barrels will soon be back on the market.

But by far the larger threat of new supply volumes reaching the crude markets is from Saudi Arabia, the only oil producer other than Iran that has any serious capacity to rapidly increase its crude exports.

Deputy Crown Prince Mohammed, who has been effectively running Saudi oil policy since late last year, threatened in the Bloomberg interview just before the Doha meeting that the Kingdom could ramp up its current 10.2 million bpd output to 11.5 million and up to 12.5 million bpd if needed within six to nine months.

Now free of the output freeze commitments, the Deputy Crown Prince has indicated Riyadh will do just that, competitively supplying crude wherever customers can be found. The threat is clearly aimed at Tehran, the only major oil producer scrambling to increase its exports to customers in Asia and Europe to get to its pre-sanction output levels of around 4 million bpd plus as quickly as possible.

We understand the Kingdom can increase its output here and there from its existing fields fairly quickly, but that the main signal of its intentions and capacity to execute any export increases would be most highlighted in any kick start to the still stalled output from the neutral zone Khafji oil field shared with Kuwait.

Output from the Khafji field was halted in October 2014 over a dispute between the two countries, allegedly over environmental concerns. The Kuwaitis were irritated by the manner in which the Saudis shut the production down, and output was also shut down in the nearby, smaller Wafra field that is mostly in the Kuwaiti part of the zone in May last year.

The dispute dragged on until just a few weeks ago when Kuwait announced a resolution of the dispute. The Saudis, however, at the time never seemed to sign off on the announcement. But we now understand the last of the disagreements have indeed been resolved, meaning the Saudis and Kuwaitis can and probably will start within weeks to bring the additional 300,000 or so bpd to market.

Russian Recoil

While Russia is not actually capable of increasing its crude oil exports as rapidly or as convincingly as the Kingdom, the debacle in Doha and the sense the Saudis cannot be trusted — ironic in that the Saudi lack of trust in the Russians is what originally drove the Saudis towards the freeze — is now driving a series of changes in Russian energy policy that point to more supply coming to the market than previously understood.

Russian output is currently understood to total around 10.8 million bpd, which was the January baseline to which Moscow was going to adhere to in the now abrogated freeze agreement. That is in fact pretty much right on Russia’s maximum capacity, which is one reason Moscow was so willing to cooperate with the Saudis and other oil producers to freeze output at January levels.

Despite vowed intentions to increase capacity, Russia admittedly has limited room to increase its exports by much more than perhaps 100,000 or so bpd. So it is our understanding — confirmed by the analysis of our sister service, Petroleum Policy Intelligence — the more aggressive shift in Russian oil policy to maximize output and market share is more about preventing a widely anticipated decline in output through this year.

Furthermore, and perhaps more strikingly, Moscow is also reversing its previous oil policies built around the freeze to accelerate plans for foreign direct investments to build up production capacity in Rosneft and other key Russian energy companies. Among the strategic investors being cited are India’s ONGC and China’s CNPC.

Moscow is also planning to soften the blow of planned tax increases on the energy sector. The changes in the wake of Doha are designed to shore up existing output and raise new sources of capital for investments in the aging fields as well as in new fields to, in time, increase Russian output capacity.

Russia’s search for foreign investors in its energy sector was also going to be a central plank to the historic visit by the Saudi king, Salman bin Abdul Aziz al Saud, to Moscow that has been in the works since last year when the King’s son, Deputy Crown Prince Mohammed bin Salman, twice met with Russian President Vladimir Putin.

If the visit by King Salman to Moscow is now postponed or cancelled outright, it may also stall the Saudi commitments of up to $20 billion of investments in the Russian energy sector, as well as an intended Saudi shift in its foreign policies to balance its dependence on the United States with a new strategic relationship with both Russia and China. But Moscow, for its part, is already well under way in discussions with potential investors from Delhi and Beijing.

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