OPEC rises above geopolitical tensions and oil prices follow

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Ερευνητική Ομάδα Μελέτης «Οικονομικές Δυναμικές»

Γιολάντα Διαμαντοπούλου, 1 Δεκεμβρίου 2017

 

Background

The Organization of Petroleum Exporting Countries aims to coordinate and unify the petroleum policies of its member countries to stabilize oil markets. Member countries together increase or decrease oil production to try to achieve desired supply levels and prices, based on a unanimous vote. This is not always easy because of internal contradictions between OPEC members. The coalition accounts for more than 40 percent of the world’s oil supply, but when it engaged in price wars with the U.S. shale producers its market share slightly decreased.

The organization’s reaction was strong. In November 2016, OPEC nations agreed with other oil producing countries including Russia to rebalance the oversupplied oil market helping the prices surge from a dramatically low point. In the organization’s meeting in Vienna the countries made the historic decision to drop their production by about 1.2 million barrels per day to 32.5 million. The importance of this deal lies in the crude oil producing countries univocally cooperating after eight years to prevent the failure of oil markets. The first months of the deal’s implementation pushed oil prices above $50. On July 2017, another OPEC meeting in Vienna took place, where the production cuts were extended until March 2018 to safeguard the rising prices.

The immediate result was oil prices rising above $60 in the third quarter of 2017, reaching two-years highs. In the November 2017 OPEC monthly report, oil demand for the first three quarters of 2017 was shown to be 1.6 million barrels per day higher than in 2016. This has supported higher prices, and is a positive sign for global demand and oil prices in the year ahead. An important factor was China’s recession, since the country is the biggest net importer of crude oil in the world. The current strong compliance to the production decrease along with a continuing strong demand and a more modest production from non-OPEC members could lead to a rapid decline of inventory at the pace of 670,000 barrels a day. The coalition decided to discuss the future of the oil cuts on their meeting in November 30th, 2017. There are many factors shaping this meeting.

 

Saudi Arabia

This meeting took place at a crucial time for Saudi Arabia. In the beginning of November, Saudi Arabian crown prince, Mohammed bin Salman, arrested prominent figures of the country, including princes, ministers, and business owners with the aim of investigating them for corrupt dealings. These anti-corruption measures led to a positive reaction from the markets as they considered the prince more successful in consolidating his power. His vocal support of extending OPEC output cuts in the past further enhanced the oil-positive view of the event. As a result, the direct implication of the measures were higher oil prices. In the past, political uncertainty in Saudi Arabia has translated to higher oil prices as well. As far as the prince’s political agenda is concerned, high oil prices are necessary. They are the basis of economic reforms that include the public offering of shares in state-owned oil company Saudi Aramco and that are needed to solidify his role as heir to his father throne. Therefore, he has been a strong advocate for extending the oil cuts for longer than March 2018.

 

Iran

Iran’s recent economic updates are affecting this meeting as well.  In the production-cut deal agreed in 2016, Iran was allowed a small increase in production since it had been partly freed from past trade embargoes erected by the U.S. Last month, U.S. President Donald Trump decided to de-certify JCPOA (the Joint Comprehensive Plan of Action, also known as the “Iranian nuclear accord”). This decision probably won’t have an immediate impact on oil prices, but it will deter new investments in the country. As the market approaches a balance between supply and demand, the uncertainty over Iranian export flows could result in the rise of oil prices. If OPEC decides to extend the cuts, Iran would benefit from higher oil prices since the country is planning to increase production in 2018. The question is whether the country’ exemption from oil cuts will continue or not.

 

Saudi Arabian and Iranian Conflict

The two OPEC members have historically strained relations, but recent events are building up stronger tensions. Saudi Arabia not only launched the anti-corruption purge, but was involved in the resignation of Lebanon’s prime minister which occurred during the same week. The former prime minister Saad Hariri, blamed Iran, and Hezbollah for his decision to step down and mentioned an assassination plot against him. These statements that took place through a televised broadcast in Saudi Arabia further intensified the animosity between the Sunnis (Saudi Arabia) and Shi’a (Iran, Hezbollah). The rise in oil prices that followed the event could be attributed to the market perception of tensions in the Middle East going forward.

An armed conflict between the two countries would have a major impact on oil markets and the global economy in general. Oil prices would depend on the severity of the conflict. For example, the unrecognized Iraqi Kurdistan, in a state of continuous war managed to export approximately 550,000 barrels per day through Turkey. In this case, on the first day of an armed conflict, oil prices would rise to $150-$200 because of panic. If Saudis and Iran attacked each other’s oil facilities, crude oil prices could reach $300. Both Saudi Arabia and Iran understand how crucial oil is to their economies, and would possibly try to maintain production even in the event of a war. Saudi Arabia currently has a budget deficit of 10 percent of GDP, while Iran has only begun to increase oil exports after a partial lifting of the past U.S. sanctions. A reduction in their markets share, even temporarily, would allow the U.S. and other countries to take their place. Therefore, if such a war takes place the states will do everything possible to continue producing and supplying oil.

Currently, geopolitical tensions between Iran and Saudi Arabia are at the highest in more than a year. They could spill over into the negotiations of the 173rd OPEC meeting and affect additional OPEC and non-OPEC agreements to extend oil production cuts. Without an additional extension of oil production cuts or at least without a significant extension, oil prices could come under some short-term pressure, which is not in the economic interest of neither state.

 

Russia

Another key player that could affect the extension of the oil cuts is Russia. The country is not a member of OPEC, but its position as a partner of many countries in the Middle East and its strong oil producing presence has led to the country’s participation in OPEC agreements. The cooperation between OPEC and non-OPEC members has been crucial in the stabilization and rebalancing of the oil markets.  The 2016 deal between members of OPEC and Russia under which Russia agreed to cut output by 300,000 barrels per day has negatively affected its economic growth. This raises a question of whether the country would handle additional cuts or their extension.

Key players such as Russia and Saudi Arabia that have strong interests in removing or extending the cuts must find common ground. Neither country’s interest aligns with very high prices that can attract the increase in production of other oil producing states, or with very low prices that could damage their budgets. A main driver to Russia’s agreement to the extension of the cuts is to create a clear schedule of their termination. The state’s complex economic policy that results in a floating exchange rate that fluctuates along with the oil price creates a greater need for stability and clarity concerning the way the cuts will end. This will allow Russia to provide guidance to the privately-owned Russian oil companies concerning future oil output. OPEC members can also benefit from a clear picture of how the output cuts will be exited.

 

Expectations

All these events were building up to OPEC’s 173rd ministerial meeting on 30th November 2017, where oil producing states would discuss the future of the oil output cuts. Three scenarios were possible after OPEC’s 173th ministerial meeting. The first scenario would be the extension of the cuts up to the end of 2018. In this case the market would probably experience a gradual rise in prices, but the U.S. shale oil production would still be expected to weigh on the market. The second scenario would be the postponement of the decision-making to the next meeting to observe the market changes and then to decide on the duration and volume of the cuts. Finally, the third one would be the conditional and flexible renewal of last year’s agreement. In other words, the deal would be extended considering the market demands for OPEC oil in 2018.

The third potential outcome has been the one expected from the market. In case it was the coalition’s actual decision, OPEC would consider an increase in demand as the International Energy Agency and the organization itself have forecasted, and would allow the members to increase production based on demand growth. What makes it the most desirable is the fact that the market would maintain its balance. As a result, nations with concerns about their budget deficit and economic situation would be able to compensate to some extent for the barrels that would be cut. In contrast, in the case rising tensions and expectations of extended oil production cuts led to the market’s disappointment, oil prices could come under short-term pressure.

 

The meeting

The 173rd OPEC meeting concluded with the expected decision to extend the OPEC production cuts for an additional 9 months (January 2018 through December 2018).  At the same time, during the 3rd OPEC and non-OPEC ministerial meeting that followed, ministers added a provision to review the production cuts based on market fundamentals at the programmed June 2018 OPEC meeting.  The extension was the desired outcome for Saudi Arabia while the provision to review was a concession to Russia’s interests. After the announcement of the OPEC agreement, prices rose, but as the non-OPEC discussions began, prices started to decline. As the ministers delivered their final remarks prices again rose as all parties decided to remain committed to the production cuts. The cuts aim to bring oil inventories down at least 150 million barrels from current levels, which is even more ambitious than the OPEC/non-OPEC coalition’s stated goal of reducing them to the five-year average. OPEC’s base case market analysis currently indicates that the 1.8 million b/d in OPEC/non-OPEC production cuts would need to continue through all of 2018 to bring down inventories to the five-year average.

Another issue that was addressed during the meeting was the level of non-compliance from some member countries. While overall the coalition has conformed at more than 100%, it has not been homogenous across the group. The new agreement issued a combined 2.8 million barrels per day output cap for OPEC members Nigeria and Libya, which were not signatories to the earlier accords. Iran was actually granted »wiggle room» to increase production in light of the upcoming sanctions’ effect. Saudi Arabia’s minister said he would assume the co-chairmanship of the monitoring committee overseeing the deal, alongside his Russian counterpart. That would ensure their leading role in monitoring the extension process.

For the extension to be successful, unity within OPEC alone is not enough but it should be combined with the support of non-OPEC partners. The recent developments signal the development of a more positive relationship specifically between Saudi Arabia and Russia. Both countries have an interest in maintaining a balanced oil market, and the 9-month extension was the middle ground between their economic interests. There have also been discussions within the coalition to institutionalize the OPEC and non-OPEC cooperation framework, and further build on the foundations that have already been laid.

OPEC producers are committed that any exit from the oil cut deal «will be gentle,» and support that is still premature to consider how to exit the cuts. The market is wondering whether a war for market share through price drops will take place when the current deal ends. The coalition should be aware that low oil prices are equally damaging to the global economy as unreasonably high prices. The Saudi Arabian energy minister is confident that many countries will experience natural declines that will facilitate the OPEC/non-OPEC bloc to exceed its 1.8 million b/d in committed cuts. He said that members would not just open the taps and flood the market when the deal ends but the coalition should decide how gradual the easing of supply will be.  His approach is to decide realistically who has spare capacity between now and year-end 2018 and come up with a beneficial scheme for the market.

 

Conclusion

Geopolitical risk has had very little influence on oil prices in the last three years due to the enormous supply. After the extension of the production cuts the market will be much closer to balance, with inventories falling back to average levels. The tighter market conditions will provide more salience to geopolitical risk. The recent meeting’s outcome signals that nations are willing to make concessions and cooperate in the name of economic interests. It is evident that the competition from the U.S. oil producers has been a key factor in the alignment of OPEC and non-OPEC countries’ interests. At the same time, it is uncertain how stable the common ground established by Russia and Saudi Arabia is, considering the June review, while Iran’s and Saudi Arabia’s political conflict could break out at any moment. In my opinion, small steps aimed at ensuring the market’s stability are a positive sign even if overall countries have conflicted economic interests and relations. If oil producing nations continue putting their economic interests first, there is hope for a stable oil market.

 

 

Sources:

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  3. Nick Cunningham. 2017. Business Insider. [ONLINE] Available at: http://www.businessinsider.com/war-between-iran-and-saudi-arabia-could-radically-change-oil-markets-2017-11. [Accessed 30 November 2017].
  4. Alex Lawler, Rania El Gamal, Shadia Nasralla. 2017. Reuters. [ONLINE] Available at: https://www.reuters.com/article/us-opec-meeting/opec-russia-agree-oil-cut-extension-to-end-of-2018-idUSKBN1DU0WW. [Accessed 30 November 2017].
  5. Myra P. Saefong and Barbara Kollmeyer. 2017. MORNINGSTAR. [ONLINE] Available at: https://www.morningstar.com/news/market-watch/TDJNMW_20171130354/update-oil-prices-mixed-as-traders-weigh-reports-of-9month-extension-to-opecled-outputcut-pact.html. [Accessed 30 November 2017].
  6. 2017. Seeking Alpha. [ONLINE] Available at: https://seekingalpha.com/article/4128230-oil-price-comes-focus-opec-meets. [Accessed 30 November 2017].
  7. Adam Vaughan. 2017. The Guardian. [ONLINE] Available at: https://www.theguardian.com/business/2017/nov/06/oil-price-rises-to-two-year-high-after-saudi-arabia-purge. [Accessed 30 November 2017].
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