Saudi-Russia Relations Mean Opec+ ‘Deal’ Will Continue. At What Price?

Venezuela’s output collapse enabled Opec and the 10 non-Opec countries party to the December 2016 output deal to tout ‘compliance’ of 129% for December. Whilst this is a flawed metric (MEES, 26 May 2017), it is one on which Opec increasingly chooses to focus. And the figure was likely even higher for January. With a further collapse in Venezuelan output far more likely than a rebound, this gives potential cover for those (few) countries to have intentionally limited output to increase it over the coming months without any talk of a formal end to the agreement.

Mr Falih, speaking last week in Muscat, said “we should not limit our efforts to 2018. We need a longer framework for our cooperation.” Saudi Arabia had long been one of the more far-sighted Opec members. Former oil minister Ali Naimi long realized that, given the massive oil reserves of Saudi and other core Opec members, the best way to maximize ultimate revenue is to boost market share even if this means lower prices in the short term – an argument that has only become more prescient amid talk of looming ‘peak oil demand.’

But since Mr Falih took over in 2015, Saudi Arabia has switched from a ‘market share’ strategy to one of cutting output to support prices. Mr Falih answers to Saudi Crown Prince Muhammad bid Salman. The crown prince’s flagship policy is the successful flotation of state oil behemoth Saudi Aramco. And to get a valuation anywhere near his $2trn estimate will require firm oil prices. With the IPO delayed, likely to 2019 at least as far as any international element is concerned, this need for firm prices will not be going away anytime soon.

Russia, to defy expectations, has more or less complied with its output cut pledge (if you leave aside the fact that its 11.2mn b/d late-2016 baseline for output cuts was patently unsustainable). But the country’s oil firms, including state giant Rosneft, have been investing heavily to expand Arctic production and are champing at the bit to do so.

Saudi Arabia and Russia have seen a massive improvement in bilateral relations over the past year despite the fact that differences over Syria and Iran have not gone away. And the Opec+ deal can take a large part of the credit. This is so much the case that for both countries the continuation of the deal (in some form) has become an aim in itself – irrespective of oil market fundamentals.

Mr Falih, in a 23 January interview with CNBC, said he hoped Saudi-Russian energy cooperation would last “decades and generations.” Mr Falih and his Russian counterpart Alexander Novak have been feeling the love as have crown prince Muhammad and Russian president Vladimir Putin. The Saudi minister was a guest of honor at December’s launch of Novatek’s Yamal LNG project deep in the Russian Arctic. “If we continue to work the way we do, we will turn from rivals into partners. All benefit from joint work,” Mr Putin told Mr Falih according to comments carried by Interfax News Agency. “That’s why I’m here,” Mr Falih apparently replied.

There is next to no chance that Russia will unilaterally abrogate its side of the deal. But it is not hard to imagine the Saudis giving Russia a quiet nod to increase output, perhaps to “compensate” for lost Venezuelan production and to “help balance” the market.

So a win-win for the two key partners to the deal.

Saudi wants firm prices, Russia will not rock the boat, and enough other countries in Opec – from Algeria, to Ecuador to Nigeria, to Iraq and Libya (MEES, 2 February) – have budgets so severely stretched that they are addicted to repeated upward re-definition of what they consider to be a ‘fair’ oil price (see below).

Whether a sustained period of near (or above) $70/B crude is in the interest of Opec members’ long term revenue-maximization is another question.

METHODOLOGY TWEAK

Saudi Energy Minister Khalid al-Falih notes that the official goal of the December 2016 ‘Opec+’ deal – to draw down OECD oil stocks to the 5-year average – represents a blunt measure of market rebalancing. The longer the deal, which entered force in January 2017, continues the more that the average rises: the average would ultimately be hit even without cutting stocks. So, if the aim, as the minister says, is to reach a “normal level” of stocks to “rebalance the market” then this is a poor measure.

At the 21 January press conference marking the end of the Joint [Opec/non-Opec] Ministerial Monitoring Committee meeting in Oman, Mr Falih floated the idea of following a metric more reflective of market rebalance, that of days of forward cover in consuming countries – as touted by MEES (MEES, 19 January). Such a metric would automatically adjust the definition of a ‘normal’ level of stocks in line with growing (or indeed falling) global demand: if a country’s oil demand grows by 10% then stocks should also grow 10% to provide the same level of cover.

Sounds sensible. But the devil is in the detail. The larger problem with the current methodology is that it only covers the OECD group of mostly rich countries where oil demand is near-stagnant. So changing from looking at absolute stock levels to ‘days of forward cover’ whilst continuing to focus just on the OECD would not dramatically change the assessment of whether the market is rebalancing or not.

The inclusion of rapidly-growing emerging economies such as India, China and southeast Asia would radically alter the picture, however. For them a substantial growth in stocks is needed just to stand still in forward cover terms. So fully adopting such a methodology could well lead to the conclusion that global oil stocks are already at or near a ‘normal level.’ Current market signals – Brent at $70/B and strong backwardation – are also strongly suggestive of market tightness.

But there’s a snag. Stocks data outside the OECD is patchy-to-non-existent. Mr Falih did propose looking at forward cover on a regional basis. But without the data, the OECD will likely remain the key focus.

RISING STOCKS, FALLING COVER

This makes a key difference. If one were to continue with the current methodology, or indeed switch to ‘days of forward cover’ but for the OECD alone, then the figures may well point to a delay in rebalancing to 2019, and possibly beyond given US output is rising rapidly in response to higher prices.

Even for the world as a whole, stocks may well grow rather than contract this year when measured in absolute rather than ‘days of forward cover’ terms. The latest IEA forecasts imply that global oil stocks will grow by 110,000 b/d (40mn barrels) in 2018 – presuming Opec output remains steady with December’s 32.42mn b/d. The US government’s Energy Information Administration (EIA) has the market balance essentially flat with the 2018 ‘call on Opec’ at 32.45mn b/d. The EIA now projects that US oil output will grow by 1.6mn b/d in 2018 (1.1mn b/d crude and 500,000 b/d of NGLs – MEES, 12 January), level with its projected growth in oil demand.

And analysts, including Wood Mackenzie, increasingly expect a net increase in output from other non-Opec countries.

The IEA expects Canada to add 280,000 b/d of output in 2018, as the Exxon-operated 150,000 b/d Hebron project offshore Newfoundland and Suncor’s 194,000 b/d Fort Hills oil sands project – which started up 29 January – ramp up to full capacity. Brazil’s output grew by a modest 4% in 2017 (see chart, MEES, 2 February) but it is set to surge in 2018 with five 150,000 b/d-capacity deepwater FPSOs totaling 750,000 b/d set to begin operations. The IEA, which has Brazil as being the largest single grower in production out to 2040 (MEES, 24 November 2017) reckons this will translate into average 2018 output gains of 170,000 b/d.

And whilst Opec could until recently take comfort that near-term additions were coming from either projects approved years ago or short-cycle tie ins, there are increasing indications of a return to exploration.

This is particularly the case in the deepwater. A 22 January report from Oslo-based analyst Rystad Energy found that a “flurry” of upstream project approvals in 4Q 2017 meant that “delayed projects sanctioned during 2017 more than doubled over the combined count in 2015 and 2016.” Of large upstream projects delayed after the 2H 2014 oil price collapse, some 18 were approved in 2017 versus just two in 2015 and five in 2016. The jump in approvals has been particularly strong for the deepwater with the project ‘backlog’ falling from 31 at end-2016 to 24 a year later.

And, if anything the pace has since picked up further. Recent Brazilian bid rounds attracted bumper interest, including from key majors, as did this week’s award of Mexican deepwater acreage – nineteen blocks were awarded with Shell taking 12, including four in partnership with QP (MEES, 2 February).

CATCH 22

The more that Opec looks like it is defending a price (and whatever Saudi Arabia’s Mr Falih says about ‘rebalancing’ other Opec members are more focused on plugging their budget deficit – see below) the more that it spurs future non-Opec output and the more that it pushes back any point in the future when Opec countries might increase their market share.

Opec risks being stuck with a ‘lower for ever’ market share strategy.

TARGET, WHAT TARGET?

“Will the extension of Opec-led supply cuts through to the end of 2018 have the intended effect” asked a key session at this week’s Chatham House Mena Energy conference in London. Which begs the question: ‘What is the intended effect?’ Is talk of “rebalancing” really code for higher prices?

Whilst the bulk of Opec ministers are no doubt sincere when they say they covet price ‘stability’ above all else – lack of economic diversification means several have seen their revenue both double and halve within the last ten years – they can’t resist repeatedly redefining what they consider a ‘fair’ oil price. And, needless to say, despite all the evidence of a massive leap in US shale output in response to $60/B-plus crude, their redefinitions of ‘fair’ have a clear upside bias.

It is certainly striking how few Opec representatives – who, when prices were in the $40s said $50-55/B was “fair” and when it was $55/B said $60/B was “fair” – have suggested that $70/B Brent might be too high. This is despite the fact that any sustained period of Brent in the mid-$60s or above (ie around $60/B or above WTI) has long been flagged up as the price range that US output will soar, whilst interest in the global deepwater is also picking up rapidly.

Nigeria’s oil minister Emmanuel Kachikwu says he expects Opec to “protect” current price levels which he calls “reasonable”

US crude output broke through 10mn b/d for the first time since 1970 in November (see below) – at 10.038mn b/d it was a mere 6,000 b/d shy of the November 1970 peak, a level it has likely topped since, with the EIA forecasting further growth to a whopping 11.2mn b/d by the end of next year (MEES, 12 January).

Iran has often been a price hawk in the past, but oil minister Bijan Zanganeh this week repeated that he would “prefer… around $60/B… with little fluctuation.” This would provide “sustainable revenue” for Iran, whilst, he hopes, remaining insufficient for a major ramp up in US shale production.

Whilst forward hedging by US shale producers means that this year’s output will likely hit new record levels almost irrespective of the oil price, many analysts feel that a sustained $60/B for WTI – around the mid-$60s for Brent – would see a further leap in shale drilling activity.

Other Opec members have never paid much more than lip service to solidarity with the Opec+ deal. Iraqi oil minister Jabar al-Luaibi, speaking at Chatham House this week, brushed off Saudi Arabia’s recent naming and shaming of Iraq’s non-compliance whilst at the same time setting out (ambitious) plans to raise its southern export capacity to 5mn b/d (MEES, 2 February).

The collapse in Venezuelan output – at 1.78mn b/d for December it was down almost 500,000 b/d on average 2016 levels (MEES, 12 January) – together with the fact that the organization has chosen to define ‘compliance’ in a way that excludes Libya, whose production is up 600,000 b/d over the same period – means that the organization has touted 100%-plus compliance rates despite only three members – Saudi Arabia, Kuwait and the UAE – having meaningfully and intentionally cut output .