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OPEC’S RETURN

Will the agreement help reduce oil production and increase prices in the long term?

Author:

15.12.2016

OPEC decided to regain its former authority. For the first time in eight years, the cartel decided to cut the production quotas. Just a few days following the decision, some non-OPEC oil-producing countries supported it. The agreement reached on November 31 will be effective starting January 1, 2017 and provides for the reduction of oil production comparable with the level of October 2016.

 

The Chief Mediator

OPEC reached the agreement in a difficult situation. This year alone, the member-states tried twice, unsuccessfully though, to agree at least on freezing the production. OPEC was torn by political tensions between Saudi Arabia and Iran. Iraq opposed production cuts reasoning that the country was fighting with IS militants, which requires financial support. This argument has supported the skepticism of experts on the eve of the cartel’s meeting in Vienna.

The oil market sensitive to various statements made by officials did not bode positive outcomes. Before the meeting, the price of Brent crude oil dropped from almost $49 per barrel to $46. In these circumstances, the decision of the cartel to cut production by 1.2 million bpd, limiting the production level to 32.5 million bpd, was very positive.

According to Bloomberg, Russia has played a decisive role in reaching agreement between the OPEC member-states. A phone call made by the Russian Ministry of Energy, Alexander Novak, to his Saudi counterpart, Khalid al-Falih, on the night of November 29 allowed to break the deadlock in reaching agreement on production cuts. Bloomberg reports that Novak promised the Saudi Minister to cut oil production in Russia, not to freeze it, as previously assumed, and even his help in encouraging other countries to join the initiative on production cuts.

The main mediator, who helped to overcome the contradictions within OPEC, was the Russian President Vladimir Putin. According to Reuters, Putin has mediated between Saudi Arabia and Iran. His diplomatic efforts started in September 2016, when on the sidelines of the G20 summit in Hangzhou he met with the Saudi Prince Muhammad and agreed to cooperate on reducing excess oil volumes in the world market. On November 28, just before the OPEC meeting in Vienna, Putin urged the Iranian President Hassan Rouhani to accept the deal, which played a crucial role in reaching the agreement.

 

OPEC for Price Increase

As a result, Saudi Arabia has agreed to take over most of the production cut volume, some 500 thousand barrels. Iraq will reduce the production by 200 thousand barrels, United Arab Emirates and Kuwait – by 130 thousand barrels. Though Iran disagreed to cut production, but expressed willingness not to increase it by more than 90 thousand bpd, whereas Iran has previously insisted on the increase by as much as 300 thousand bpd. Some exceptions were made to Libya and Nigeria, which have already reduced production volumes due to the fight with terrorist groups, as well as Indonesia, which announced the suspension of activities in OPEC. These quotas will be in effect for the next six months and re-examined at the OPEC meeting in May 2017.

OPEC's decision has immediately led to an increase in oil prices by 9% in just a single day, on December 1. In the following days, the prices continued to rise hitting $54 per barrel. Then the price has slightly decreased due to market uncertainty in the implementation of the Vienna agreement and the possibility of reaching an agreement production cuts by non-member-states. But they did not disappoint the efforts.

 

Historic Agreement

On December 10, eleven countries outside OPEC agreed in Vienna to cut production in January next year at 558 thousand bpd from the October level. Russia will take over most of the reduction (300 thousand bpd), Mexico – by 100 thousand bpd, Oman – 40 thousand bpd, Azerbaijan – 35 thousand bpd, Kazakhstan – 20 thousand bpd, and the remaining volume of 63 thousand bpd will be split among Bahrain, Brunei, Equatorial Guinea, Sudan, South Sudan, and Malaysia.

The Saudi Minister of Energy, Khalid al-Falih, called OPEC’s decision and its support by the above countries a historic one. Not only due to its market effects, but also due to the number of supporting countries. He stressed that OPEC would follow the commitment to cut oil production in accordance with the arrangements, assuring all countries as the future president of OPEC.

According to him, six months should be enough to balance the market. “By the middle of next year, we should ideally return to the production level when everyone will be able to produce as much as he wishes, and we will not be setting these limits all the time,” said Khalid al-Falih. However, the minister did not rule out that there could be a clumsy situation, when it would be required to cut production again. By the way, the signatory countries will be able to extend the term of the agreement for another six months depending on market situation.

In general, the global decline in oil production will reach 1.7-1.8 million bpd. The Russian Ministry of Energy, Alexander Novak, said that rebalancing of the oil market as a result of these arrangements might occur in the third quarter of next year. Moreover, the agreement is open to accession by other exporting countries.

 

Azerbaijan and Kazakhstan will not fail

Azerbaijan will easily fulfill its part of the Vienna agreement. No major projects on the launch of new oil fields are expected, which could dramatically increase production.

Even before the recent agreement, Baku has lobbied actively on balancing the market. Moreover, in October, in his interview to RIA Novosti, President Ilham Aliyev said that Azerbaijan had unilaterally decided not to increase oil production.

“In general, the attitude of oil exporting countries is in favour of the increase in oil prices to $60, maybe $70 per barrel. I think this would benefit everyone: companies that would have funds to invest and producing countries, which could attract funds for various projects”, said the President.

A completely different picture is on the eastern shore of the Caspian Sea, where Kazakhstan after several years of waiting has launched a large-scale Kashagan project. That was the main reason Kazakhstan was not ready to participate in the recent talks, but finally agreed to reduce the production slightly by 20 thousand bpd. As explained by the Kazakh Minister of Energy, Kanat Bozumbayev, Kazakhstan will fulfil its obligation by reducing production at other fields.

 

Market Expectations

The price of Brent crude oil soared to $57 (5% growth in comparison to the previous week) on the first working day after the agreement on last Saturday. According to Fitch’s forecast, even the absence of any agreement with non-OPEC countries can remove the excess supply in the market and lead to a gradual reduction of oil reserves in OECD (Organization for Economic Cooperation and Development ) countries in 2017. Moreover, based on the forecast of the International Energy Agency (IEA), Fitch experts believe that the oil demand can exceed supply by about 400 thousand bpd in the first quarter of 2017 and 1.3 million bpd in the fourth quarter 2017, if the term of the agreement is extended.

Most experts, including Goldman Sachs and Bank of America, expect $60 per barrel in the near future. The forecasts for the following year are also optimistic, but take into account the ability of countries to reduce production, as well as the likelihood of increased production in other non-signatory countries. According to the forecast by Wood MacKenzie, the average price of oil in the next year will reach $65-70 per barrel, if OPEC member-states and other producing countries adhere to the terms of reduction plans. The analysts at Bernstein believe that the realistic forecast annual average oil price for 2017 and 2018 will be $60 and $70 per barrel, respectively. Morgan Stanley also expects higher oil prices in 2017, however, warns that the plans for Libya and Nigeria to increase production are still the main threat to OPEC estimates for rebalancing the market.

Vice-president of Lukoil, Leonid Fedun, suggests that $60 per barrel will be the dominant price throughout 2017. He notes that due to a shortage of large-scale investments in the industry, production cuts may be unnecessary in the future. “We must understand that the market has lost almost $1 trillion during these three years, when the prices were low. This is the money that was not and will not be invested in new fields in the near future. Therefore, the market will miss at least 6-7 million barrels by 2020,” said Fedun.

He noted that under such circumstances, and in a number of unforeseen circumstances, the oil price in the long term could return to $100. Although, according to Fedun, too high a price is not profitable for the producers. “$80 per barrel is a golden mean, which serves as a balance between supply and demand”, explained Fedun.

But one should keep in mind to what extent the country agreed to reduce production will follow the stated quotas. Particularly, Russia will have difficulties in this regard. According to the Russian Minister of Energy, Aleksandr Novak, Russia will reach the production level of 300 thousand bpd only in April-May 2017.

On the other hand, the market will watch closely after the American companies developing shale oil shale deposits. The rapid growth of shale oil production in the US has resulted in the current price crisis.

According to the head of IEA, Fatih Birol, the US shale oil producers will increase production as soon as the price of oil reaches $60 per barrel. The US companies has become significantly stronger over the period of price wars within OPEC being able to reduce production costs to $29.44, and up to $15 in North Dakota.

According to Hamza Khan, head of commodities strategy at ING, OPEC was too late with the decision to reduce oil production, as the US producers have managed to significantly reduce costs and adapted to produce oil at $40 per barrel. “When the initial euphoria subsides, the American manufacturers of shale oil will increase production because this decision is, in fact, means that they celebrate Christmas 26 days ahead of schedule”, said Khan commenting on the OPEC agreement.

At the same time, one of the main risks for the next year is associated with the possible implementation of the promise given by the US President-elect Donald Trump on eliminating all impediments to the development of the energy sector, including oil.

IEA forecasts that in the long term, the oil demand will grow until 2040 and reach 103.5 million bpd (a 12% increase in comparison with 2015). The oil prices will rise to $79, $111, and $124 per barrel by 2020, 2030, and 2040, respectively. This rise inter alia will be due to the increase of production costs, as the era of ‘light oil production’ is coming to an end.

Thus, contrary to many pessimistic predictions, one can say that OPEC is ready to show its former power, when only a single declaration of intent to reduce or increase production would be enough to mood swings in the market. The willingness of non-OPEC countries to join joint actions in the market adds to the reliance of the cartel. On the other hand, the cartel faces some challenges too, such as the readiness of countries to comply with quota agreements and the war with the US shale oil producers.

Only time will tell if OPEC regains its former glory or is doomed to collapse and oblivion.



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