Shared Production Cuts - The Impossible Dream

Background

As everyone knows and is quick to point out in nearly every oil-production discussion, Saudi Arabia has traditionally been a swing producer. Because of their spare capacity, low-cost oil, and production levels, Saudi Arabia could play a bit with oil supply to keep prices steady.

(As an aside - it's generally thought that OPEC's role was to keep prices high. Or low, depending on what people think this week. However, OPEC's primary role was to stop the rapid fluctuations in oil price that occurred in an unregulated oil market.)

However, Saudi Arabia can only modify the price of oil through supply changes in a small range. We've just undergone a massive fall in price. To give an idea of the scope of the cuts that would be required, in Nov 2014 Russia and OPEC met to talk about shared cuts to bring the price of oil, then around $80/barrel, back up to around $100/barrel. At that time, Russia suggested that Saudi Arabia cut a full seventh of their production just to fix that small (relative to what happened later) price drop.

Obviously, Saudi Arabia would have to make massive cuts to their production levels and, if they managed to raise the price, high-cost producers like the US, Canada, and Russia would simply increase production, dropping the price again.

This happened to Saudi Arabia once before (1980-1986), and it was a disaster for them. They're understandably reluctant to do it all again. So they've repeatedly tired to hammer out an agreement with other major producers, mostly Russia, for shared cuts. Russia has repeatedly refused to co-operate on any production level changes.

Until now.

Brent crude futures pared gains Tuesday following news that Qatar, Saudi Arabia, Russia and Venezuela would lead an effort to freeze output at January levels, dashing hopes of a cut in production.

What's Changed?

This recent semi-agreement is very probably driven by two major factors. The first is that Russia is probably really hurting financially at this point. Practically none of their oil is profitable at $30/barrel, and with the real possibility that the price will go lower, they're probably getting anxious.

The other factor is that Iranian trade sanctions have been lifted, and there's another million barrels of oil a day ready to enter the world markets. That's guaranteed to drive the price lower. Russia would probably like very much for that to not happen.

The Deal

The deal that's been hammered out by Saudi Arabia, Venezuela, Qatar, Russia, and Iraq is fairly obvious in intent, at least according to the reports in the media so far - they want to freeze oil production at January's levels. Here's how that would affect each nation, including Iran:

Saudi Arabia - already producing near maximum capacity, so a production freeze has no effect on them at all.

Venezuela - already producing at maximum capacity, so a production freeze has no effect on them at all.

Qatar - production in serious decline for years now, so a production freeze has no effect on them at all.

Russia - already producing at maximum capacity, so a production freeze has no effect on them at all.

Iraq - has doubled their production in the last ten years, and may be nearing maximum capacity. Even if not, they're in a good position production-wise, so not hurt too badly by a production freeze.

Iran - producing at 1 mmbpd below their pre-sanction levels, so a freeze would prevent them from recovering their full production capacity.

Of course, Iran has said "no" to this arrangement. It's not clear from reports if any concessions were made to Iran due to its special circumstances, but just on the face of the deal as reported, there's zero incentive for them to agree to it.

Possible Outcomes

The fact that any kind of deal, even a bad one, has been worked out with Russia indicates the level of desperation these producers must be feeling. Trying to stop Iranian oil from entering the market is surely a beginning step, and intended to stop further collapses in price rather than to raise the price.

Shared production cuts, as opposed to a proposed freeze, between these major producers is, in my opinion, unlikely at this time. If they occurred, and if they were successful in raising the price of oil (not at all certain, see below), then all that would happen is that US and Canadian production would increase, again driving the price down.

This is probably the biggest obstacle to cuts by major producers. There's another one, however, although less certain.

Prices have largely collapsed due to poor economic conditions. Industrial activity is slowing, trade is slowing, global economic growth is slowing, and possibly even flat, depending on how inaccurate China's economic figures are. Oil prices can't rise without the need for more oil (increasing industrial activity) and the ability to pay sustained higher oil prices. Neither of those conditions are likely with the poor economic situation the world is in.

So my own suspicion is that even if there's a miracle and shared cuts occur, they won't raise prices as high as they were, and probably not in any sustained fashion. Barring, of course, some kind of major state economic intervention in the markets.

Lastly, one interesting factoid - total global liquid fuel production peaked in August of 2015, when oil was selling for $50/barrel. Since then, production has decline by a million barrels a day, and the price of oil is now $30/barrel. Something to keep in mind when assuming that a decreased supply automatically means a price increase.