The market vacillated last week between euphoria and despair over the hopes for an Opec production cut. On Tuesday, Brent prices rallied 5.6 per cent when Bloomberg headlined that “all hands are on deck to meet November 30 target” for an approved deal. On Wednesday and Thursday, however, prices sagged after Nigeria, Iran and Iraq decided not to send their oil ministers to informal Opec talks in Doha, diminishing expectations for a successful deal.
What is going on? The problems are manifold, from excessive gamesmanship and compliance issues to the unique situations of the various producers.
Although Opec usually talks of production cuts, exports matter more. Imagine that oil prices went up, leading to an increase in the price of petrol in, say, Saudi Arabia. If a Saudi driver paid more for petrol, the Saudi government would be better off, but the driver would be worse off, with Saudi Arabia as a whole exactly where it started.
By contrast, if the price of oil exports go up, then the Saudi government and, through government spending, the Saudi people would both be better off. Therefore, exports – not production – are the key to a deal.
Oil exports in turn depend on volumes produced and not consumed at home. Countries such as Kuwait, which are big producers but have small populations, are at an advantage. Oil export revenues per citizen are high, and any price increase makes a big difference in per capita national income.
Iran stands at the other end of the spectrum, with a population of 80 million, but limited oil exports. While the Saudis export approximately 8.5 million barrels per day, the Iranians export only 2 million bpd. This makes Iran volume-sensitive. A 200,000 bpd cut for Saudi Arabia is only 2.5 per cent of its exports, but represents 10 per cent of Iranian exports. Therefore, Iran needs a larger increase in price to compensate for any production freeze. For example, if a production cut increased oil prices by $7 per barrel and Iran froze production at current levels, the country would net only US$1.3 billion more in export revenues than from anticipated 2017 production gains at lower prices. It’s hardly worth the effort for Tehran.
Iraq stands somewhere between Saudi Arabia and Iran. Here, too, a production increase is arguably necessary, in this case, the full 130,000 bpd which some analysts believe Iraq can achieve. This would boost Iraqi export earnings by $9bn, a more appealing sum.
Saudi Arabia, other Gulf producers and Russia would have to bear the brunt of supply cuts. But even this is not so simple. The global oil supply was up a whopping 1.4 million bpd in October, partly from a recovery of production in Nigeria and Libya. Even more came from Russia, which is not an Opec member and which added 500,000 bpd in the past two months.
Therefore, Opec’s proposed production cuts in September of 200,000 bpd to 700,000 bpd are not enough. Net cuts of 860,000 bpd (using as a baseline production levels at the time of the Algiers meeting in late September, at which the Opec countries agreed in principle to cut production) could do the job, and appear to be about as much as the participants can handle.
Of this, the Saudis would contribute 420,000 bpd, the Russians a hefty 550,000 bpd, and other GCC countries another 250,000 bpd. The optics for the Russians are bad. Nevertheless, the Russians have only themselves to blame. Their surge of production in the past two months may be enough to kill the deal outright. If the Russians want an agreement, they will have to walk back their ill-conceived supply increase.
If we take the numbers a as a whole, the kingdom’s output would be capped around 10.1 million bpd, and Russia would be limited to 10.9 million bpd. This would not entirely eliminate excess supply, but would reduce it substantially and bring the markets into balance during the first quarter of next year, raising oil prices substantially.
The magnitude of a resulting price increase has been much analysed. Earlier, investment banks tended to forecast the benefit at $5 to $10 per barrel. More recently, however, market observers have concluded the differential is greater. Gus Majed, founder of the London-based trading firm Beca Capital, said that without a deal, oil could easily fall below $40 per barrel and Saudi Arabia and Iran would be at loggerheads, “leading to a repeat of the 2014-15 price crash dynamic. Conversely, a meaningful deal will see Brent rising to $60 per barrel and backwardation emerging, with prices climbing to $80 per barrel in 2018.” Even in the short term, a production cut could be worth $20 per barrel.
With such a price differential, the Russians and Saudis would earn outsized returns of about $50bn per year, despite contributing the largest production cuts. As Iran and Iraq export far less oil, their gains would be limited to the $15bn to $25bn range, but would generate returns higher than those of Russia and Saudi Arabia in percentage terms.
A deal faces obstacles. First among these is compliance. Again, only exports matter, as only these affect global oil prices. Exports are transported by pipeline, tanker and lorry, and all these can be monitored by sensors, tanker spotters, and satellites. It is not that difficult.
Finally, an Opec deal needs only to cover through to the end of 2017. With the cuts outlined above, global excess inventories should run off by that time, and quotas can be renegotiated.
From the technical perspective, an Opec production cut is entirely feasible. However, the participants need to demonstrate some understanding of and empathy for issues facing different countries. It is time to set aside differences and finalise a deal.
Steven Kopits is the president of Princeton Energy Advisors in New Jersey
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