Try as they might, members of the Organization of the Petroleum Exporting Countries (OPEC) will have a difficult time finding consensus on oil production levels when the cartel members gather in Vienna later this month.
The members of OPEC, along with Russia and a handful of smaller non-OPEC producer countries, has, for the most part, achieved its 2016 goal of rebalancing the world’s oil markets by draining national stockpiles and pushing the international benchmark price of oil to roughly $75 a barrel. The revenues of OPEC countries are now at their highest levels since oil prices collapsed in 2014.
The cartel now finds itself at a crossroads over its two-year-old supply cut agreement. OPEC’s heaviest hitter, Saudi Arabia, is facing serious internal divisions and a host of thorny geopolitical issues that provide no clear path forward. That’s because Saudi Arabia and Russia have already signaled a willingness to ease the cartel’s 1.8 million barrels-a-day production cut deal. The Saudi-Russia discussions have eased a price surge that had driven oil above $80 in May. Traders now expect OPEC to open the taps, so any reversal or revolt among the cartel’s members would be a red flag to the bulls.
The two most important players in the production-cut deal have already moved, quietly increasing production. Saudi output in May rose 100,000 barrels a day compared to April, hitting its highest level since October. May marked the third consecutive month that Russia failed to fully comply with its own 300,000 barrels a day production cut. Top Russian producers Rosneft and Gazprom Neft have recently told investors how quickly they can resume full output.
The problem is that other than Saudi Arabia, Russia and a handful of smaller Gulf member states, the rest of OPEC wants the production cuts left unchanged. While Saudi Arabia, Russia, Kuwait and the United Arab Emirates (UAE) have spare production capacity, the same cannot be said for the remainder of the 24 members in the OPEC/non-OPEC pact. Iran, Iraq, Venezuela, Angola and others producing nations have vocally opposed an end to the quota deal.
Such divisions are not uncommon within OPEC, but they had a better chance of being smoothed over before it was revealed that Washington was putting pressure on Riyadh to increase production to offset barrels that will be lost once the United States re-imposes sanctions on Iran. America’s long-time foes Iran and Venezuela are outraged by the revelation so much that it could threaten to bring down the 60-year-old cartel. “Crazy and astonishing” is how one Iran official described the U.S. request – a feeling that could easily spread to other members of the cartel, particularly among those nations lacking spare production capacity who don’t stand to benefit from ending the production cuts.
It remains to be seen how Saudi Arabia and Russia – a country that has never been thrilled about subsidizing the booming U.S. oil industry – will navigate this sticky wicket. One option is to keep the deal in place but reduce the group’s “over-compliance,” the result of so many countries’ inability to produce at target levels.
Compliance with the output cuts has been running at more than 150%, thanks mainly to the meltdown of Venezuela, but also because of faltering output because of underinvestment in countries like Angola, Algeria and Mexico.
Because of this, the Saudis and Russians should have room to maneuver. After all, it was not just the United States that was concerned about rising oil prices. China and India, the most coveted oil import markets in the world, also expressed concerns. OPEC and its partners could officially keep the deal in place while making vague promises to meet global oil demand, a move that could see those cartel members with spare production capacity gradually increase output.
The underlying problem is that the end of the production cuts will shift attention to the fact that global spare production capacity is becoming scarce.
The more Saudi Arabia and Russia produce, the less spare capacity they have in the event of a future supply disruption. With President Donald Trump bringing back harsh sanctions on Iran, the quickly approaching total collapse of Venezuela, and a number of geopolitical hotspots flaring up in and around OPEC member nations, there is real cause for concern over the loss of spare capacity. It was spare capacity concerns and supply threats that pushed oil prices to their all-time high of $147 a barrel in 2008 – a spike that only subsided when the global financial crisis erased demand for oil.
Growth in the U.S. shale sector should be sufficient to meet rising demand in the near term, but a major disruption on top of renewed sanctions could spark a new run-up of prices.
Weak upstream investment outside the United States has eaten away at global spare capacity. As it stands, Saudi Arabia holds the vast majority of spare capacity at around 2.5 million barrels a day. Kuwait and the UAE could potentially put another 500,000 barrels a day into production, while Russia has indicated it could increase output by 300,000 barrels a day.
All that is fine and good, but in a global market of 100 million barrels a day, a 3.3% margin of error is not a big confidence booster. Regardless of what happens in Vienna later this month, the smart money is on prices resuming their upward trend sooner rather than later.