The art of the deal?


The background

The previously awesome power of OPEC, whose members represent 44 percent of global oil production and 81.5 percent of the world's ‘proven’ oil reserves, has been on decline since the cartel’s heyday in the late 1970s. Following a disastrous, OPEC price war on US shale from 2014 to 2016 during which the OPEC states lost a collective US$450 billion in oil revenues and the US shale sector reorganized itself effectively to cope with lower prices. There were finally attempts to strengthen crude prices in 2016 with production reductions that included other important producers, most notably Russia in a configuration known as OPEC+. This allowed for the price of oil to be relatively stable around US$50 per barrel essential for balancing the budgets of the world’s most important petro states as well as ensuring the profitability of large-scale shale producers in the US and Canada.

A double shock

The increasingly dire global economic crisis due the spread of the Covid-19 virus has had a catastrophic impact on oil prices, as they have fallen 70% since the beginning of the year. In the midst of this global demand shock, entered geopolitics. In early March, OPEC presented an ultimatum to Russia to reduce production by 1.5% of world supply.

Russia refused, seeing potential opportunities to decisively reduce US shale oil output, which from 2017 to 2019 had risen from 8.9 mmbopd (million barrels of oil per day) to 12.7 mmbopd – becoming in the process the world’s largest crude oil producer. In response, on March 8th, pushed by an ever more powerful Prince Mohammed Bin Salaman, Saudi Arabia initiated a “shock and awe” strategy announcing price discounts of $6 to $8 per barrel. Saudi Arabia followed up on March 10th announcing a production increase from 9.7 mmbopd to 12.3 mmbopd, with Russia increasing by approximately 300,000 mmbopd. This price war triggered a free fall in oil prices, with Brent crude falling by 30% in the largest drop since the Gulf War, causing a wider crash in financial markets worldwide.

The Russian strategy seemed clear, the Saudi one less so. Economically, Russia is the producer that has the lowest break-even price of crude required to balance the national budget at 40$ per barrel and foreign asset reserves perspective for up to 10 years. The Saudis on the other hand, despite the world’s lowest production costs, require a price of $84 per barrel and have foreign reserves of only 2 years.

Trump to the rescue

On April 9th under enormous pressure from the Trump administration, supposedly including a threat to Saudi Arabia to block military aid, and after one month of bitter price war, the members of OPEC+ came to a truce agreeing to cut daily production by nearly 10 mmbopd from October 2018 volumes. Already a historic cut on its own right with Russia and Saudi Arabia taking on about half of the cut, it has been widely reported that cuts by other non-OPEC+ producers including the United States, Canada, Brazil, and Norway will bring an ulterior 10 mmbopd reduction.

This deal has been reported as a diplomatic coup on the part of President Trump who had the objective of propping up the US shale sector, essential for his reelection prospects and reminded the world of the United States influence, able to force recalcitrant countries around a table to strike an ambitious deal. This was also seen as a win for Russia’s President Vladimir Putin, as he was able to strengthen his bilateral relationship with Trump, having held five bilateral conversations since March 30th, more than in the whole of 2019. Despite bringing Russia back into OPEC+ the overall loser has been Saudi Arabia in general and MBS in particular. The Saudis succeeded in almost ruining their relationship with Russia (essential both as an energy partner and for its influence in Syria and Iran), and alienating its only significant ally, and further worsened their already difficult economic situation. Despite a further recent round-up of political opponents, MBS’s position remains weakened as his judgment is increasingly called into question.

Outlook: a hollow victory?

While oil prices rose to $28 per barrel following the announcement of the agreement, oil prices went back down and ended this week on the decline at just above $20 per barrel. US WTI settled at $19.87, levels not seen in 18 years. Regardless of the political implications, it is the economic outcome that seems to be the most at risk. First of all, significant doubts remain over the feasibility of coordinating and implementing an unheard-of 20 mmbopd cut across a wide set of countries, many of which - Russia, Iraq, Nigeria - have histories of OPEC target non-compliance. More fundamentally, the IEA now estimates that demand this month will be roughly 29 million bpd lower than the same period last year, and still off by 26 million bpd next month. Hence supply will still continue to strongly outpace demand rendering any significant increase in prices highly unlikely in the near future.

The economic outlook therefore remains grim. Worsening economic conditions will well require deeper cuts over the coming months that will be even more politically challenging to negotiate and impose. Furthermore, as inventory stocks increase due to the low prices, this will put more pressure on oil prices and reduce the power of OPEC in all its variations. According to the IMF, oil prices at these levels “could result in more than $230 billion in lost annual revenue across MENAP oil exporters compared with October projections, placing significant strains on already weakened fiscal and external balances.” The impact of this negative economic shock on the politically unstable region that is the Middle East, without forgetting the ongoing global pandemic is difficult to foresee but will almost certainly be negative.

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