What are we to make of last week’s deal to freeze oil output between Saudi Arabia and Russia – the world’s two leading crude exporters? Is it significant and is the price of oil now likely to rise?
This agreement is remarkable in the sense that there typically isn’t much love lost between Riyadh and Moscow. While Saudi has traditionally been the beating heart of Opec, Russia has always sat staunchly outside the 56-year old oil exporters’ cartel, just like the Soviet Union before it. The fact that the Desert Kingdom has long been a US-ally (albeit to varying degrees) has also helped stoke Russo-Saudi tensions.
With Chinese oil demand doubling over the last decade and Russia using it geographic proximity to build pipelines and lucrative long-term supplies deals with Beijing, eating in Saudi’s global market share, the rivalry between these two energy giants has lately intensified. Most recently, of course, they’ve been on opposite sides of the Syrian civil war, with Saudi and Turkey backing opposition forces, while Russia and Iran have propped up the regime of Bashar al-Assad.
Despite all that, we’ve just witnessed the most significant oil supply deal since Saudi announced that Opec would raise production into the face of falling prices in 2014 – a move specifically designed to drive prices down further and knock upstart yet high-cost US shale producers out of the market. Having watched crude fall 70pc in just 18 months, and with a budget deficit close of over 15pc of national income, Saudi’s powerful oil minister Ali al-Naimi is now putting down a marker.
“Freezing at the January level [of production] is adequate for the market, we believe,” al-Naimi said last week. “We recognise supply is going down because of current prices and we also recognise demand is on the rise.” The Russian government, too, while less dependent on oil revenues than Saudi, will also be relieved if crude prices significantly rise.
The first thing to say about this deal – which also included Opec-members Venezuela and Qatar – is that, despite representing a major diplomatic development, it’s far less important in terms of oil supply than it initially seemed. The agreement was to maintain production at January levels, rather than cut, and it so happens that among the two main signatories last month’s output was already sky-high. Russia pumped 10.9m barrels a day in January, a post-Soviet record, while Saudi produced 10.2m barrels, the highest January level in 35 years.
Far from a production limitation exercise, then, this was more of a commitment to keep crude flowing at maximum capacity. On top of that, “quota-cheating” (already rampant within Opec, as cash-strapped governments over-produce to garner extra revenue) could be even worse given this deal goes beyond the cartel’s membership.
Yet oil rallied almost 10pc when this unexpected Saudi-Russian détente hit the news wires. Prior to that announcement, there was no inkling talks were even taking place. We saw further price rises on Thursday, after Iran “endorsed” the move by Riyadh and Moscow to cap production, with crude rising almost 15pc over two days. Commodity price bulls were further boosted by reports that US crude stocks were down last week, falling 3.3m to 499.1m barrels, compared to market expectations of a 3.9m-barrel rise.
Having said that, it soon became clear that Iran, despite being in Opec, won’t limit it’s own oil output. That would be “illogical”, the Iranian government disclosed, given that the country has just regained access to international markets. Prior to sanctions imposed in 2012, Iran exported 2.5m barrels of oil daily, with international restrictions cutting shipments to 1.1m barrels today. Now sanctions are being lifted, Tehran is determined to regain some of its global market share. That reality, combined with ancient enmity towards the Saudis, makes it difficult to imagine Iran capping its own oil exports, let alone agreeing to an Opec-wide cut.
Something needs to give, though, because Riyadh is clearly getting desperate. The fact that Saudi and Russia are even talking and announcing any kind of deal – the first between a member of Opec and a non-member for 15 years – suggests that Riyadh’s resolve is weakening. The country burnt through a staggering $120bn of reserves during the last two months of 2015, a stomach-churning 16pc of the declared total.
US-based ratings agencies piled on the pressure last week, with Standard and Poor slashing Riyadh’s sovereign debt rating another two notches for the second time in five months. There is increasing chatter in the market the Saudi authorities may have to abandon the riyal’s peg to the dollar, leading to a depreciation that could provoke political unrest.
For now, the Saudis are putting on a brave face, insisting they won’t be forced to retreat from their battle for global market share by implementing an explicit production cut. The sweating of the US shale industry is to continue. Having said that, the fact that the oil price rose so strongly on signs of a Saudi-Russian deal, and held on to some of those gains even when all the caveats emerged, suggests that some investors, at least, feel the oil market could be close to touching bottom.
That would certainly make sense. The lack of profitability across the US energy sector has seen the number of operational oilrigs fall from over 2,000 just a few years ago to 514 in mid-February. For more than half a century, the US oil industry has operated over 500 domestic onshore rigs. It now seems inevitable America’s bellwether “rig count” will fall below 500 once more, a grim milestone that’s testament to the extent to which investment in US oil production has lately dried up as prices have fallen. That trend, replicated in many higher-cost producers across in the world of course, contains the seed of future price rises.
The world’s biggest economies could soon get drawn into a negative spiral of low growth and falling investment as market fears about the global recovery become “self-fulfilling”, Moodys warned last week. Slashing its oil price forecasts to $33 in 2016 and $37 in 2017, down from $53 and $60 in November, the ratings agency warned that a crude glut would keep prices low, piling pressure on the world’s biggest oil producers.
The low-crude pain extends to Britain, of course. North Sea producers have axed 65,000 jobs since 2014, with industry leaders now warning of “total meltdown” unless prices improve. Across America – which remains a major oil importer, and where low fuel prices would ordinarily spark unequivocal joy – there is growing alarm not just at the job losses suffered by domestic crude producers, but, in particular, the state of their balance sheets.
Over recent months, as this column has often pointed out, the poor cash flows of US energy companies have stymied their ability to pay creditors – including many big Wall Street banks – who readily put up money to fuel the “US shale miracle”. With distressed debt now at levels not seen since the peak of the financial crisis, American energy bonds are being dubbed “the new sub-prime” – and could pose broader systemic dangers.
I don’t agree with Moody’s that oil prices will average $33 this year and $37 in 2017. This crude collapse, which entirely contradicts the long-term fundamentals of ever-rising global oil demand and the geological and logistic constraints on future increases in supply, is largely about geo-political brinkmanship.
When the geopolitics shifts – or at least seems to shift, as we saw last week – then prices will quickly rise to more rational levels. Quite frankly, that can’t happen soon enough.