The Vienna Deal: Only Temporary Relief in Oil Markets

By: Dan_Steinbock

The Vienna agreement among OPEC and non-OPEC oil producers will extend oil cuts by nine months. After the deal, oil price plummeted by about 5 percent. Far more is needed to subdue new economic uncertainty and market volatility.

Among the oil insiders, the decision to extend oil production cuts was seen as a done deal well before last week's Vienna meeting. But as I have argued in the past few years, investors seek assurances of longer production cuts. That is vital in an era of huge energy overcapacity.

The Vienna outcome is critical to all energy importers. But why is it that oil producers seem to restrict their debates to shorter-term cuts, even though patient capital considers longer-term cuts warranted?

The oil glut of the 2010s

The current oil glut originates from surplus crude oil in 2014–2015. Accelerated in 2016, it was fueled by oversupply as US and Canadian shale oil production reached critical volumes, geopolitical rivalries amongst oil-producing nations, the eclipse of the “commodity super-cycle” due to the deceleration of Chinese growth, and perceived policy efforts away from fossil fuels.

As recently as 2012, the world price of oil was still above $125 per barrel, and remained relatively strong above $100 until September 2014. The sharp downward spiral ensued thereafter as oil price plunged below $30 in January 2016.

Moreover, the production of the Organization of the Petroleum Exporting Countries (OPEC) was poised to rise further with the lifting of international sanctions against Iran, even as markets were oversupplied by 2 million barrels per day.

As the initial OPEC meetings failed to lower the ceiling of oil production, despite great overcapacity, what followed was a deep oil price meltdown. It heralded a new wave of destabilization that contributed to diminished global growth prospects.

In this status quo, the ability and willingness of the 13-member oil cartel to agree on such a ceiling, even on a temporary basis, supports stability while contributing to global growth; at least as long as its OPEC and non-OPEC participants comply fully.

Any new exemption or expanded production volume or ineffective compliance undermines OPEC’s effort to push up prices by extending cuts.

From the first cuts to the Vienna deal

Between August 2016 and February 2017, oil prices increased by 20 percent, mainly thanks to the agreement by the OPEC and other producers to cut oil production. After some weakening, oil prices stood at $50 a barrel at the end of the first quarter, soaring to almost $55 right before the Vienna talks.

Today, Riyadh needs stability to cope with domestic economic challenges, amid its war against Yemen. That's why Saudi Arabia agreed last fall to the first output cut since 2008, accepting a “big hit” on its production, while permitting its regional rival Iran to freeze output at pre-sanctions levels.

Consensus was not automatic. In the past few months, Iran and Iraq, the second- and third-largest OPEC producer respectively, have sought exemption from further production cuts. Following talks, Iraqi Oil Minister Jabbar al-Luaibi and his Iranian counterpart Bijan Zanganeh supported the extension, along the lines of a plan agreed by Saudi Arabia and Russia, the largest OPEC and non-OPEC oil producers, respectively. A bad deal was better than no deal, in which case oil prices would plunge again, which would hurt them even more.

Russia has supported the cuts all along because, in the absence of adequate diversification, Moscow remains dependent on oil revenues. As long as the prices remain steady and on the upside, Russia’s economic growth is secured.

The extension also benefits the United States and the Americas, due to their shale and offshore oil and gas resources.

Inadequate extensions, global pressures

However, as the post-Vienna price declines evidence, the extension is inadequate. The rebalancing of supply and demand is still seen at least some 18 months away, after the buildup of stocks over the past three years.

Even before the Vienna meeting, skeptics thought that oil prices may not exceed $60 in 2017-18 because oil markets are under secular transformation, bargaining power has shifted from advanced economies to emerging nations, and new alternatives (shale, renewable) are capturing more space. Sluggish demand will ensure that further cuts will be needed as prices will remain subdued.

New pressures will ensue. When dollar goes up, oil tends to come down. Oil is denominated in US dollar, which is intertwined with the Fed’s policy rate. As the Fed will continue to hike interest rates that could contribute to further turbulence, particularly in those emerging and developing economies that are amid energy-intensive economic development.

In the short-term, the Vienna extension of production cuts is necessary but not sufficient for a sustained global recovery. Despite abundant inventories and sluggish demand, seasonal demand is likely to rise in the summer in the Middle East, which may make compliance challenging. Stronger US production is likely to delay rebalancing.

Moreover, there are several potential geopolitical storms – the Riyadh-Washington military cooperation but dissension about oil market’s future, the continued need for exemptions by Iran and Iraq and some other major producers, the new normal of oil demand in large emerging economies, the economic implications of President Trump’s pro-Israel policies in the Middle East and so on - that could undermine the ability or the willingness of OPEC and non-OPEC to sustain consensus about production cuts.

Even in the most benign two-year scenario, increasing divisions about production cuts are likely to keep prices relatively subdued for a protracted period. Far more is needed for peaceful, stable and sustained global prospects.

Dr Steinbock is the founder of the Difference Group and has served as the research director at the India, China, and America Institute (USA) and a visiting fellow at the Shanghai Institutes for International Studies (China) and the EU Center (Singapore). For more information, see http://www.differencegroup.net/

The original, slightly shorter version was published by South China Morning Post on February 28, 2017

© 2017 Copyright Dan Steinbock - All Rights Reserved

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