In 48 hours: D-Day for Opec

Nick O'Connor

Picture a three-way Mexican stand-off in which everyone is gunning for everyone else, but on an epic geopolitical scale. At stake are trillions of dollars, supremacy of a vital global market and national pride.

That’s what we’re seeing today in the oil market.

And the next 48 hours could decide who comes out on top.

In one corner we have the Gulf States like Saudi Arabia, Iran and Iraq – Opec. In another we have Russia. The final player is the US. They’re all seeking to strike a blow that will cement their position as the dominant player in the oil market.

On Wednesday morning Opec meets in Vienna. Over a breakfast meeting (I always think that’s strange – why meet over breakfast?) the world’s most powerful oil producers will try to come to an agreement over supply cuts.

In principle the deal was agreed in September: Opec cuts production by somewhere in the region of 600,000 to one million barrels of oil a day. The goal is to “firm up” the price around $50. But that’s proving easier said than done. Opec is under pressure both internally and from abroad. We’re about to see whether it’ll crack.

First, a quick look at the economics

According to some estimates it’s a pretty simple equation. An output cut of one million barrels per day would only need prices to rise by $1.60 to pay for itself. The case for a cut on those terms seems simple.

If only!

You can’t just look at this from a pure economic standpoint. Because on a number of levels oil is just a proxy for national pride and geopolitical tension to come to the surface.

Let’s look at the internal pressure on Opec. As I explained it last month, a cartel is only as powerful as it is united and weak as it is divided. If its key players – Saudi Arabia, Iraq and Iran – can’t agree, then its effectiveness as a bloc is eroded.

That’s what we’re looking out for this Wednesday. Since September’s agreement in principle to cut production, there’s been a lot of posturing over whether it’ll actually happen. Iran wants to be exempt from cuts as it ramps up its output following the lifting of economic sanctions. Iraq is also rumoured to want exemption.

Here’s the problem: the more nations claim exemption from the cuts, the weaker the agreement.

For starters, other nations like Saudi Arabia would have to make up the difference, cutting more of its own output to cover for Iraq and Iran. That essentially gifts market share to its regional rivals.

But this isn’t just about the money or market share. It’s about whether Opec can act effectively as a unit and execute its agreed strategy. If the deal collapses on Wednesday it’ll be another telling sign that it can’t.

That’s the internal threat

What about the external?

Well, let’s jump thousands of miles north of the Gulf’s oil producing states to Russia. It’s worth pointing out that in October Russia’s oil output was higher than Saudi Arabia, Iraq and Iran.

That’s significant for several reasons. It means that – if Russia wanted to – it could sit back, watch Opec cut output… then ramp its own output up in return and gain market share.

From Opec’s point of view, that’s too big a risk to take. Which means Russia needs to be brought into the fold as part of any agreement. Cue closely watched negotiations between Opec and Russia. No one knows quite how those talks have gone. On Friday a “last ditch” negotiation was cancelled when the Saudis pulled out. Now there are rumours that talks are back on.

We won’t know exactly what’s happened until Wednesday. It seems unlikely Russia will cut output. But it may agree to freeze it. If it does, and Opec can actually agree, we may get that output cut.

I suppose it’s logical to ask: why would Russia go along with that deal? Power, status and influence would be my answers. If Russia is a key part of the deal then it cements its place as a powerbroker in the oil market. That might well come in useful in the future, if Russia were to need something from Opec.

Those are two shooters in our Mexican stand-off. What about the third?

That’s the US. Specifically, the shale and tight oil producers that started this whole fight when they ramped production up so much as to threaten Opec’s supremacy, forcing Opec to flood the market and drop the price.

For much of oil’s slide over the last few years, shale producers were seen as the real losers. The consensus was that the industry needed a high oil price to survive.

And it did

But the price at which the industry is viable has dropped like a rock. The bear market tested shale producers sorely. It forced them to cut back, become more efficient and innovative. Where once the key oil price level for shale was north of $100, it now seems closer to $60. (There are some shale regions that have breakeven prices of $45 – it depends on the geographical makeup of the shale deposits.)

That introduces a fascinating element. I showed you a few weeks ago that there were a record number of short positions against the price of oil. One theory is that the shale producers are short oil as a hedge against Wednesday’s decision.

If that’s true, it creates something of a win-win for shale:

If Opec agrees on output cuts and the oil price rises… more shale wells become viable operations, meaning they can scale their production back up.

If Opec doesn’t agree and the price falls… they benefit through their short position.

Shale producers won’t be in the room on Wednesday in Vienna. Not literally, anyway. But they’ll cast a long and haunting shadow over proceedings.

Three key players gunning for one another. A huge industry at stake. Who blinks first?

Who’s your money on? I’m on

Until tomorrow,

Nick O'Connor's Signature

Nick O’Connor
Associate Publisher, Capital & Conflict

PS If the deal doesn’t come off as expected on Wednesday, expect Opec to claim that rising demand will pick up the slack. That may well be, but it’s out of Opec’s control. And as I’ll show you later in the week, we could actually be approaching “peak-demand” for oil much sooner than people think. Stay tuned for that one.

Category: Geopolitics

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