Oil prices have steadied recently at the $52-53 levels, not because of the deadly hurricanes hitting the US and Mexico on fear of oil production disruption, although major US refineries shut down in Texas, but because there is a feeling that the March 2018 OPEC and non-OPEC agreement might be renewed adding to market certainty.
Commodity dealers are split, however, with some not confident that the March 2018 agreement will be renewed. They argue that the Russian Presidential election will have concluded by March 2018 and that both a re-elected President Putin and some Russian oil companies who have been reluctant to join the earlier production cut agreements, will not feel obligated to join any new renewal agreement.
They point out that the long awaited market rebalancing of global stocks has not occurred and that long term global oil demand is going to be affected by decisions taken for environmental friendly renewable energy and a switch from petrol and diesel to electric and hybrid vehicles.
They also point to some persistent non-compliance by some OPEC members in not meeting their production quotas, and the exemption of others like Iran, Nigeria and Libya, which unsettles the market as these countries production rises and falls.
Above all they point to the continued resilience of American shale production which has benefitted from somewhat higher and steadier oil prices to ramp up production and delay the expected market rebalancing. They argue that countries like Saudi Arabia should abandon their current cooperative policy and go back to maximum production, even if this pushes down prices to $20 per barrel level.
Financing the American shale boom through borrowing from high yield debt capital markets cannot also be sustained foreverDr. Mohamed Ramady
High cost producers
This would drive US shale and other high cost producers like Brazil and Canada out of the market and allow Saudi Arabia and others with similar low cost production capacity to dominate market supply forces in the long run. All these are powerful arguments, but there are those who also believe that the agreement will be renewed and offer strong counter arguments.
Some argue that Saudi Arabia and its Gulf allies can now ill afford to go back to the market share, at -all -cost strategy of 2014, as there is now genuine cooperation with non-OPEC countries, principally Russia to try and stabilize production levels together. This was missing before and some non-OPEC countries needed time to adjust to a quota production system.
Despite initial skepticism on Russian compliance, the country is now meeting its 300,000 barrel per day production cut, but the lion’s share has been Saudi Arabia with actual production cuts far above its agreed 486,000 barrels per day quota.
Also read: Falih: OPEC, non-OPEC committed to cutting inventories to five-year average
The Russians, far from walking away from an agreement renewal will now welcome it given that the expected warmer level of cooperation between Russia and the US has quickly being replaced with more US sanctions against Russia, forcing that country to seek closer geo political alliances with countries like Saudi Arabia.
The Kingdom also recognizes that if the agreement is abandoned, resulting in a free for all, then this will spell the end of OPEC, as many high cost OPEC members and those under severe fiscal stress like Venezuela and Nigeria will not be able to survive.
Both the Russians and the Saudis and even the Iraqis and Iranians are signaling that the current production pact is working, and have promised to ensure greater compliance, and dismiss that their assorted energy minister’s statements are merely empty talk for the sake of talk to prop up market prices.
Other factors that support a renewal of the agreement, possibly for a longer period beyond March 2018, is the impending Aramco IPO which is expected sometimes in 2108, and a relatively high but stable oil price level will certainly help the IPO.
To have prices crash to $20 levels in the face of a change in Saudi oil policy will hinder or even delay the planned IPO. Others point out that the continued march of US shale production might not be taken for granted because of several factors.
The surge in production has been based on a combination of factors including cost reduction and efficiencies in this industry, but that these are not permanent and some of the gains are cyclical. In the face of rising US interest rates and inflation, the cost of capital equipment are likely to rise and the shale industry is beginning to see that some of the earlier low cost funding has now changed to a higher cost environment.
The shale factor
As shale production rose and the number of wells increased, so did the demand for oil service operators and skilled crew, and are now in shorter supply adding to cost pressure. These factors raises the break even cost of production in shale , and having a relatively high oil price regime because of OPEC and non OPEC cooperation also suits the shale industry.
Financing the American shale boom through borrowing from high yield debt capital markets cannot also be sustained forever, as some of the major shale operators have seen rising debt servicing costs with a reported outstanding debt of around $130 billion, putting pressure on smaller companies with lower credit rating. This could lead to defaults and bankruptcy and remove some shale output from the market. If oil prices fell sharply, the problem becomes even more serious.
Given the above factors, not extending the production cut agreement seems to be the worse of the two options, as restoring production levels to those prior of the 2016 agreement would put global oil balances quickly back into large surpluses with low oil prices.
Given that many of the Gulf countries are also in the midst of their economic transformation programs, a sharp fall in oil prices will lead to more foreign exchange reserve drawdown, adding pressure on their fixed peg currencies and credit rating.
The announcement by Moody’s Investors Services credit rating agency that it had cut Oman’s banking outlook from stable to negative led to the removal of Oman’s long serving Central Bank Governor Hamid Al Zadjali, and many Gulf companies are trying to adjust to the unintended economic and financial consequences of the inter-GCC Qatar dispute. Not renewing the oil production agreement in March 2018, by adding to these uncertainties is not an option.
Dr. Mohamed Ramady is an energy economist and geo political expert on the GCC and former Professor at King Fahd University of Petroleum and Minerals, Dhahran, Saudi Arabia.
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