OPEC: More Crude, But Lagged

Published on June 5, 2018

A curious alliance of US and Russian pressure to provide more crude supply is shaping up as the dominant driver to the outcome of the upcoming meeting of the 25 OPEC and non-OPEC oil producers in Vienna on June 22. Caught in the crossfire is the Kingdom of Saudi Arabia, with its own strategic interests to protect.

*** The so-called “OPEC+” is clearly leaning towards additional crude supply. While the Trump Administration may favor the one million barrel figure bandied about in St. Petersburg ten days ago — and the Russians are understood to be making the case for up to 1.5 million bpd — Saudi Arabia remains determined to keep any new barrels within the framework of the 2016 Vienna output agreement. We suspect there could in fact be as little as 300,000 bpd and no more than 800,000 bpd of additional OPEC+ crude coming, slowly, to the markets in the second half of this year. ***

*** All else being equal — with the caveat that “all else” rarely remains equal for very long — we think the base case for crude prices is a volatile trading range of $60-80. Those bounds are likely to draw an asymmetric response from Saudi Arabia and the GCC oil producers with spare capacity, with a faster reaction to tighten up on output to stem falling prices, but a slower response to rising prices with a lagged higher output channeled through the lengthy Vienna compliance monitoring process. ***

*** Further driving price volatility are bullish and bearish geopolitical uncertainties: there is the high likelihood of further deep declines in Venezuela’s crude output, for one, while Iran’s output under sanctions may not decline as much as assumed; and there is the “Trump factor” in the US pressing ahead with sanctions on both countries — with a high risk of elevated risk premiums in the confrontation with Iran — but at the same time, its pressure on Riyadh to pump more crude if prices spike too high too quickly, which the Saudis will find immensely difficult to resist. ***

Russia Gets Assertive On Higher Output

In the wake of the Saturday GCC meeting in Kuwait, it seems clear the OPEC+ group of 25 OPEC and non-OPEC countries are very likely to add more crude oil to the market through the second half of the year. But the question still unanswered is by how much and under what conditions.

The dynamics of that outcome is driven by the diverging views of the group’s two oil powers, Russia and Saudi Arabia.

Russian officials had already made it clear that Moscow intends to allow its oil companies to lift and sell as much additional crude as they can find buyers for in the coming months. That message was conveyed to Saudi oil officials on the sidelines of the conference in St. Petersburg ten days ago and passed on to the GCC meeting by the UAE energy minister after UAE Crown Prince Mohammed bin Zayed met with Russian President Vladimir Putin on Friday.

Russia’s concern is that oil prices that rise above the $80 mark may spur faster US shale output and simply bring too much volatility to oil prices, either by spurring faster US shale output or weakening global oil demand, with a sharp plunge in oil prices. Russia is far less dependent on oil revenues to fund its budget than the Kingdom and the other oil producers but is concerned about the impact volatile oil prices have on the ruble, whose stability is a policy priority.

Thus Moscow is more comfortable with an oil price around $60, as Energy Minister Alexander Novak and Putin himself have both recently affirmed. Russian oil companies are anxious to move ahead with their plans to produce more crude, and the working assumption is that it could translate into an extra output of about 300,000 bpd or more in the coming months.

To ensure the lower price target, we understand Russian oil officials have suggested to their Saudi counterparts the amount of additional supply relative to the Vienna output cuts should reach as much as 1.5 million bpd.

That is significantly above even the one million bpd that the Saudi Energy Minister Khaled al Falih implicitly but reluctantly went along with when the figure was broached in St. Petersburg. More to the point, it would also require a substantial output increase by the Saudis and to a lesser extent, its GCC allies, Kuwait and the UAE, with some spare capacity.

Saudi Arabia Remains Cautious

Saudi Arabia, we understand, is highly reluctant to commit to such higher output, apparently citing a lower figure of perhaps 500,000 bpd as a sufficient target for higher output. And while resigned to giving ground to the more assertive Russian stance, the Kingdom remains determined to limit the impact of any additional output on prices out of two strategic concerns.

The first is the Kingdom’s need for as much oil revenue as possible in the near term, to cover its budget deficits that would reduce the amounts needed in drawing further on foreign reserves or borrowing in the domestic and international capital markets. Saudi officials also have an eye on the sort of target valuation a healthy crude price would help to underpin for the delayed, but eventual partial privatization of Saudi Aramco.

Thus, in stark contrast to the Russian talk of an optimal $60 a barrel average crude oil price, the Saudis still favor a price at or above $80.

They have been arguing that higher price level would neither undermine global oil demand nor be so high it spurs the sort of US shale output that brought such turmoil to the OPEC oil producers by 2014. At the same time, demand, while solid, is not strong enough to absorb so much additional supply without the risk of prices falling more sharply or even below the $60 mark.

A Compromise within the Vienna Framework

Crucially, the second strategic priority for Riyadh is in protecting the hard-fought price gains of the 2016 Vienna agreement it had so exhaustively negotiated and with it, maintaining its mechanisms and structure as the political means to put a floor under any future sharp fall in oil prices (see SGH 5/25/18, “OPEC: Crude Crosscurrents”).

It, in turn, may provide the means to the compromise we understand the Saudis are trying to carve out at the OPEC+ meeting.

We understand the Saudis will argue to keep the Vienna framework intact by allowing for additional supply but keeping it within the Vienna framework and calling for a formal extension of the Vienna agreement through the end of 2018.

Thus Saudi officials may agree to commit to higher oil output, but as a “temporary increase” relative to the Vienna quotas, and only in response to a physical supply shortfall shock that spikes crude prices, and only with a consensus of the full OPEC+ group of oil producers.

In addition, crucially, the additional Saudi output would come through a commitment to bring compliance to the Vienna cuts down towards the 100% mark from around 165% registered in April due mostly to the steep declines in Venezuelan output.

Whether the Saudi compromise can be achieved within the OPEC+ meeting remains to be seen. As the only producer with large spare capacity, the Kingdom tends to get what it wants within OPEC. Russia, in turn, is likely to go along since it will be essentially doing whatever it pleases, participating in the OPEC+ plans in name only.

The Trump Factor

The complicating factor to the Saudi ambitions is not within OPEC+, but in its relations with Washington.

Aside from President Trump’s tweet a few months ago that “OPEC is at it again,” we understand the US pressure on the Kingdom, to keep gasoline prices down during the US summer driving season and the run-up to the November mid-term elections, has been conveyed so far through the State Department to the Saudi Foreign Ministry rather than the White House directly to the Saudi King and Crown Prince, or even to the Energy Ministry.

The spillover into oil policy of the Saudi-supported US confrontation with Iran is hard to ignore. In fact US policy is increasingly spilling over into the OPEC domain, something that Moscow is likely to push back against, even if both countries are for now aligned on wanting lower oil prices.

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