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Sun 28 Feb 2016 12:47 PM

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Sentiment a key variable in recent oil production deal

Top global oil producers - including Saudi Arabia and Qatar – have agreed on a joint action to help oil prices improve from their lowest in more than a decade.

Sentiment a key variable in recent oil production deal

Russia, Saudi Arabia, Venezuela and Qatar have agreed to freeze their crude oil production at January 2016 levels in an effort to rebalance the oversupplied oil markets. Collectively, the four nations produced over 24.2 million barrels per day (bpd) in January, accounting for more than a quarter of global oil supply and the quartet contains some of the world’s largest oil exporters.

The significance of such a step can be viewed in a number of ways, through the tangible impact the freeze will have in terms of actually limiting oil production amongst the four countries involved, and the potential implications this might have for other producers as well. However, the impact on broader market sentiment should also not be ignored, especially in a market that has been largely driven by negative sentiment so far this year.

In practical terms the significance of a production freeze will only be felt if other major producers follow suit, to which the parties to this agreement have said as much publicly. Convincing other OPEC members — in particular Iran and Iraq — to limit production growth will be a monumental challenge.

Iran has already had some success in regaining markets it had lost when sanctions were imposed in 2012 and is unlikely to heed calls to restrict output so soon after sanctions were removed.

Iraq may be unable to meaningfully raise production in 2016 but this relates more to security concerns. In parts of the country unaffected by security issues, major new projects will continue to add to global volumes as the country rebuilds its oil industry.

Libya too is producing at a fraction of its pre-civil war levels and will likely seek to maximise production if the political situation stabilises. Adherence to this agreement even among the four countries will also be under scrutiny as past instances of OPEC-Russia production arrangements have unwound messily only a short while after being agreed.

Freezing production at January levels — which for the OPEC members of this agreement was around 84 percent of their total capacity, most of which is held by Saudi Arabia — does little to address the issue of oversupply which has been hanging over the market for the past two years. Rather, it confirms that output will remain at January’s high levels for the near term.

Russian production of 10.88 million bpd was at record levels while Saudi Arabia produced nearly 500,000 bpd more than it did in January 2015. Rebalancing the market will thus be left to two fickle players; demand and non-OPEC producers.

The IEA has recently revised downward its demand projections for 2016 as the impact of low oil prices wears off and consumers prefer to save their low-oil windfall rather than spend it at the pumps.

Even if the IEA’s demand projections—1.2 million bpd this year, down from 1.6 million bpd in 2015 — are a little on the bearish side, there are no indications that demand isn’t being met or refiners scrounging for barrels. Medium-term time spreads are displaying little sign of a tightening oil balance (and indeed have worsened in the past month for WTI futures).

Limiting production at current levels also does little to address the stockpile overhang.

Without sufficient demand to keep pace, oil production frozen at 24.2 million bpd will still see some move into storage, capping the potential upside for price rallies even further down the road.

However, it is not only through limiting the supply of oil that this agreement might make a difference. The announcement of a deal might also have a constructive impact on oil market sentiment, given that it has obviously been negative sentiment that has been driving the oil market so far in 2016.

That some of the most prominent world oil producers actually came to some kind of an agreement, albeit a limited one, is a significant step forward from the situation of just a few months ago, highlighting a degree of coordination that recently was presumed to be completely lacking. Furthermore, according to Saudi Oil Minister Ali Al Naimi an output freeze is only the start of a process that could lead to other steps being made in coming months.

This takes a rather limited deal in practical terms and imbues it with much greater significance in terms of its potential, effectively rebranding it as a stepping stone towards eventual oil market stabilisation.

The deal then becomes a benchmark against which to judge future measures, and conveys the impression of oil producers starting to get to grips with the problems posed by freefalling oil prices.

As markets had previously written off any degree of coordination amongst oil producers, by selling oil sharply lower since the start of the year, the realisation that there might be the beginnings of agreement between some of the most prominent producers is a very strong counter signal that markets are unlikely to ignore.

Tim Fox is chief economist with Emirates NBD in Dubai

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reza 3 years ago

Why can't each Opec member decide what they want to do to solve the problem? Some can cut and some can freeze? Why is it all freeze or nothing? Makes no sense.