Defying skepticism that their countries could agree on any measures to stabilize global crude markets and prices, Saudi Petroleum and Natural Resource Minister Ali al-Naimi and Russian Energy Minister Novak, along with their Venezuelan and Qatari colleagues, reached agreement February 16 In Doha to freeze their countries’ output at their January 2016 levels.
Initially, global crude markets responded positively to the news with WTI pushing past $30 and Brent $34. Soon, however, the markets’ focus turned to the agreement’s limitations: neither Iraq nor Iran, both major producers, had yet to bless a freeze; freezing at January 2016 output levels effectively cemented a ~1 million barrels per day surplus; without effective monitoring and enforcement provisions, crude revenue dependent governments, as they traditionally have in the past, would cheat; and any agreement will not include North American companies.
As the day wore on, skepticism displaced optimism. As a February 16 Wall Street Journal article put it: “The more things change in the oil market, the more they stay the same: The agreement Tuesday between Saudi Arabia, Russia, Qatar and Venezuela to freeze oil output falls somewhere between symbolic significance and no change at all”. As optimism faded, crude prices retraced their gains and closed lower on the day.
Is the continued skepticism warranted? Perhaps yes, if one believes the purpose of the Doha agreement is to increase crude prices in the short term.
It isn’t, however, if in fact its purpose is to put a floor under crude prices—and as a first step in raising prices in the future.
In the following discussion, keep in mind the following numbers—2 million barrels per day and 710,000 barrels per day—the IEA estimate of readily available (within 90 days) Saudi spare capacity and Saudi Arabia’s incremental average 2015 daily output, respectively.
Fun with Numbers: Math-Driven Necessity
Crude revenue dependent governments have a powerful reason to find common ground on output levels—to varying degrees and at varying speeds, their current output policies are greasing (or is it oiling?) the skids for their country’s financial and economic self-immolation.
The 2015 monthly average OPEC basket prices are presented in the following table. (OPEC basket prices are used for this analysis since the key crude revenue dependent countries—Russia, Saudi Arabia and its Gulf Arab allies, Iran, and Iraq—compete against each other in key markets). After peaking in Q2 2015 at an average price of $59.89 per barrel (and on a monthly basis in May at $62.16) crude prices declined steadily through the rest of the year as the Saudis increased output, the P5+1 agreement with Iran became a reality, lifting of UN sanctions on Iran loomed, and Iran began to expound on its determination to increase crude production 500,000 barrels per day within weeks of sanctions’ end and 1 million barrels per day within a year.
As crude prices continued to drop in January 2016—averaging $26.50 per barrel—the IEA and many observers marveled at Saudi Arabia’s, Iran’s, and Iraq’s capability to increase crude output. The following table shows the IEA’s January output estimates for Iran, Iraq, and Saudi Arabia from the public narrative in its February Oil Market Report, and the change from average Q4 output using its January Oil Market Report. Iran’s output increased 100,000 barrels per day, Iraq’s 90,000, and Saudi Arabia’s 50,000 (Russia’s January output was not available in the February public narrative and therefore is assumed to have remained at Q4 output levels for the purposes of this discussion).
What an exercise in futility! The increases Iran’s, Iraq’s, and Saudi Arabia’s output in January resulted in substantial decreases in revenue in January for each of these countries (and all other producers)—and in potential annual revenue. The following table shows the potential loss in annual revenue Russia, Iran, Iraq, and Saudi Arabia will endure were prices to average $26.50 in 2016—Russia ~$36 billion, Iran ~$3.1 billion, Iraq ~$16 billion, Saudi Arabia ~$31 billion (each country’s actual revenues will depend on their crude’s discount or premium to the OPEC basket/competitor price. Iran’s March price for Asia, for example, is $2.60 below similar Oman and Dubai grades). Looked at in percentage terms, Iran increased output and exports in January from 4Q 2015 average output and export levels ~3.5 percent and 16.7 percent respectively—and achieved a ~22 percent drop in potential annual crude export revenue.
What would happen were Iran to increase output 500,000 barrels per day, as it claimed it would soon after sanctions were lifted? Assuming that a 500,000 barrel-per-day increase in Iranian output (to 3.37 million barrels) led to a 500,000 barrel-per-day increase in exports and caused the OPEC basket price to drop to $20 per barrel, Iran would generate $10,658,000,000 in crude export revenue, only some ~$210,000,000 more than in January when the OPEC basket case was $6.50 higher. The table below estimates annual export revenue for the four countries at $20 per barrel oil using estimated January export levels.
These estimated actual and estimated potential decreases in crude export revenues come at a time when each of these crude-export-revenue dependent governments and other crude-export-revenue dependent governments face yawning budget deficits and are searching desperately for revenue to finance their budgets. Reuters described the situation in Russia as follows in a February 4 article:
More fun with numbers! The Russian government generates a substantial percentage of its budget revenue from the customs duty on crude and crude product exports. During 2015 (and continuing on into 2016), the calculation for the crude export customs duty for US$ crude above $182.5 per metric ton ($25 per barrel) was $29.20 per metric ton plus 42 percent of the difference between $182.50 and the Ural benchmark price per ton. For crude between $146 and $182.50 per metric ton ($20-$25 per barrel), the calculation was $12.78 plus 45 percent of the difference between $146 and the Ural benchmark price.
The implosion in crude prices during 2015 resulted in the following implosion in the (estimated) amount of export customs duty the Russian government received from each ton of exported crude (from Rosneft’s 3Q and 1Q Management Reports) and therefore, its annual take from crude export custom’s duty (assuming exports at 7.55 million barrels/day):
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With crude over $100 per barrel, the crude export customs duty generated bounteous revenues for the Russian government’s budget and for its sovereign wealth funds. With crude at current prices, generating revenue from this source is a struggle. The Russian government is seeking to raise an additional $10 billion to cover a gap in 2016 budget funding that the fall in crude prices in December and January caused. The table below displays the number of barrels Russia would have to export to generate $10 billion in crude export customs revenues at various crude price levels. Russia exports ~2.7 billion barrels per year—with prices at $26.50 per barrel, it would take nearly 80 percent of annual crude export customs duties to generate $10 billion, at $20 per barrel, some two years:
Given these results, it is therefore no wonder the Russian government is forced to consider selling a portion of its stakes in such major Russian companies as Rosneft, Aeroflot, and VTB bank—this at a time when Russian asset prices are depressed and European and U.S. companies are leery of Russian asset due to Ukraine-related sanctions and the Russian economy’s recessionary conditions.
Both Iran and Iraq similarly are in dire straits. Many of the long-term economic benefits the Iranian government expected to derive from the end to UN sanctions may be receding beyond the horizon. Iran—at least Iran’s Petroleum Ministry—had hoped quickly to attract foreign capital to its efforts to ramp up crude and natural gas output to pre-sanction levels. Estimates of the amount necessary to achieve this goal vary. Reuters put the amount needed to return output to 4 million barrels per day at $200 billion.
As the end to sanctions approached last year, ministry officials announced plans to develop and present a new model investment contract to foreign investors and energy companies this February. Infighting within Iran between ministry officials and conservatives aligned with Iran’s military and security forces over who will set the terms for foreign investors, conduct the negotiations, and choose the domestic Iranian partners for their foreigners, as well as conservative opposition to any foreign investment in the oil and natural gas industry, have forced the ministry indefinitely to postpone presenting the contract. Exacerbating the difficulty of Iran’s situation, low prices are causing industry-wide cutbacks in investment spending for 2016 and beyond and to think twice about putting money into a risky and unpredictable country.
Iraq too is struggling to fund development of its energy industry. Even when the OPEC basket price was ~50 percent higher in September 2015 (~$46 per barrel), the Iraq oil ministry was writing to the foreign contractors producing Iraq’s oil (including such majors as Shell, ENI, Lukoil, and BP) warning them of impending cuts in funding for the petroleum industry. The situation has become even more difficult: as noted above, as Iraq increased output in January by 90,000 barrels per day to 4.35 million barrels per day, based on the OPEC basket price, estimated revenue dropped from $62.2 billion to $43 billion. Coincidentally, this is the amount almost to the US$ that the Iraq government announced in January it wants to raise through domestic and international bond sales to plug a $20 billion budget gap.
Given the fact that a ~$20 billion decrease in annual crude export revenue accompanied the incremental 90,000 barrels per day in Iraqi output in January, isn’t it possible that the Iraqi government might be amenable to an output freeze, if not a production rollback?
Output Freeze: Far More than Symbolic and No Change at All
At the present time and in present market conditions, most oil producing countries probably fear further declines in crude prices more than they hope for price increases—and therefore, they—including Iran—likely welcome the Saudi willingness at least to freeze output at January 2016 levels.
Only a few (major) oil-producing countries have the capacity quickly and relatively cheaply to increase output over 2015 levels—the Saudis, ~2 million barrels/day, as mentioned above, Kuwait, which has ~150,000 barrels per day coming on line in 2016, the U.S. (where companies drilled, but put off completing wells until prices improve), and perhaps Iran, the volume and ease of tapping of which is unknown. Almost all the rest produced at maximum levels in 2015 to reduce the damage to their crude revenues from the sharp drop in crude prices. Assuming they skimped on spending for oil field maintenance and containing natural depletion to fund more pressing needs, such countries may be unable to maintain output at 2015 levels, much less increase output.
The Saudis too are likely to welcome this freeze. Low crude prices have also harmed them and lower prices would harm them more. As noted above, at an average $26.50 OPEC basket price, Saudi crude exports would generate ~$31 billion less revenue than at 4Q 2015’s $39.72 average price—and, at $20 per barrel, another $17 billion less.
Also, they are freezing output at a significantly higher level than in the past—10.21 million barrels per day. In the three years preceding 2015, Saudi output averaged only ~9.50 million barrels per day. In the course of 2015, they increased average output to ~10.12 per day (output peaked in June at 10.46 million barrels per day).
These numbers—2 million barrels in readily available spare capacity and output 710,000 barrels above pre-2015 levels—put the Saudis in a strong negotiating position. The former number gives them the means to enforce an output freeze. The possibility that the Saudis could, if necessary, lift output above 10.21 million barrels per day will deter other countries from cheating. It will also continue to limit crude price increases and therefore the capability of countries and companies to invest in expanding production (as well as in maintaining production).
This applies as well to Russia and Iraq—and to Iran. Iran may protest against the Saudis and other OPEC members taking their sales in Europe and Asia after the UN imposed sanctions in 2012 and assert that it will not accept a freeze until it has regained its share in these markets. However, without the Saudis committing to output restraint and therefore removing the Sword of Damocles they hold suspended over the global crude market, it will be difficult for Iran to attract substantial investment in the foreseeable future.
The latter number gives the Saudis the possibility to act magnanimously on output levels to accommodate Iran’s output wishes, at least partially, if Iran decides to be collegial and the Saudis’ major non-North American competitors also are prepared to be magnanimous output—and still be in a better position in terms of output than it was in 2014. Igor Sechin, Rosneft’s President, cited 1 million barrels per day as the reduction in daily output volume necessary to move the global crude market toward balance.
Russia already in effect has offered its share: Transneft, the Russian crude pipeline monopoly, announced in mid-January that based on producer pipeline capacity applications, Russian oil exports in 2016 would decline 400,000 barrels per day. For their part, the Saudis could throw in 210,000 barrels per day and still produce ~500,000 barrels per day more than they did in 2014 and the beginning of 2015. With Russia and Saudi acting magnanimously, Iraq and other countries might be willing to cut output, recognizing the positive impact on prices over time.
Looked at this way, the freeze is a starting point, which, over time could lead to production cuts as major non-North American producers gain confidence in the intentions of their fellow producers and therefore bring forward balancing the global crude market. Of course, it could also lead to the opposite result, if those countries with capacity to spare see no reason for confidence.
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