Oil Deal Between OPEC and Russia – 2/17/16

What sort of oil deal could reverse the collapse in oil and gas prices that has devastated balance sheets and budgets around the world? Many believed that OPEC would always step in to keep prices relatively high only to see months of inactivity as Saudi Arabia let prices fall in a bid to regain market share from US shale-oil producers who only seemed profitable at high prices. Surprisingly robust shale production due to cost cutting and increased efficiency, in turn, led to the current long period of low prices. Countries dependent on oil such as Venezuela have been begging OPEC leaders to come to an agreement on cutting oil output to little effect until recently when Saudi Arabia, Russia, Qatar, and Venezuela called for a coordinated freeze of output levels. How effective or tenable the agreement will be when exposed to reality remains to be seen.

For Russia, the second-largest crude producer in the world, the collapse in oil prices combined with continuing economic sanctions has been devastating. A weakening ruble, significantly reduced government income, over-reliance on natural resources to fuel growth, and widespread corruption are just a few of the challenges facing the country. Despite Russia’s agreement to freeze output, an actual cut in output seems unlikely. Besides purely technical issues like the difficulty of stopping and restarting wells in the freezing regions of Russia’s primary oil reserves or a lack of crucial storage facilities, the country has, historically speaking, cheated OPEC in the past.

When it comes to output cuts, Russia is not a reliable partner. Although, OPEC has more or less managed to deliver the optimal result of a Prisoner’s Dilemma when it came to the cartel’s output cuts, its de facto leader, Saudi Arabia, has no reason to trust Russia to meet its obligations. Trust was first lost in 2001 when Russian officials broke a deal with OPEC by increasing exports instead of meeting cut obligations. In more recent affairs, Russia is basically fighting a proxy war with Saudi Arabia as it bombs Saudi-backed rebels in Syria. Additionally, the two nations has competing to be China’s oil supplier. Russia is also in need of more revenue to fund other foreign operations in Georgia and Ukraine as well as a military modernization effort which Putin has been reluctant to scale back. Some cheating on output limits is not uncommon but putting faith into partners with a history of selfishness and active undermining of your interests is not a recipe for a stable relationship. Even the freeze agreement, conditional on other nations agreeing to participate, seems like a stretch.

Iran will likely reject attempts to bring it on board with the output freeze. Following the recent lifting of sanctions on the nation, Iran has been preparing to boost output and exports to begin regaining market share, and though the nation has voiced support for the freeze it has been more coy on the subject of its own contribution to the effort. A superficial cap on Iranian production may be possible but Iran is not likely to abandon its planned increase in output of 1 million barrels a day during 2016. Given that Iran is expected to be one of the largest contributors to the continued glut such a gesture would do little to change the fundamental mismatch of supply and demand. Oil revenue, low price or no, is vital for Iran, like Iraq and Saudi Arabia, in financing military opposition to ISIS forces.

In the end, the agreement will likely be remembered as Saudi Arabia and Russia throwing a symbolic bone to weaker producer nations. Desperation from Venezuela led the country to campaign hard for actions to restore oil prices and end the crippling economic consequences that have led to superinflation, GDP declines over 5%, and collapsed government revenue for much needed social programs and import of essential good. No matter how “historic” officials may claim the oil deal is, supply outmatches demand by millions of barrels a day. No increase in demand are likely to appear and there is little chance seeing of voluntary output cuts necessary for a short-term rebound in oil prices. Stockpiles rise and rise to the point of overflow going to floating tankers. It is sure to continue to be a volatile year for oil.

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