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Dec 2, 2016 | 09:15 GMT

10 mins read

In OPEC, Every Deal Is Flawed

On Nov. 30, OPEC members agreed to a long-awaited deal to slash oil production.
(JOE KLAMAR/AFP/Getty Images)
Forecast Highlights

  • Rather than substantially boosting prices, OPEC's agreement to cut its oil production will lower the risk of prices dropping even further.
  • Though the amount of output the bloc intends to cut is significant, cheating among the deal's signatories will probably prevent OPEC from reaching its target.
  • The reduction will help to push the market back into balance, but any notable price increases could revive North American shale production and undermine OPEC's attempts to buoy prices in the long run. 

After nearly two years of squabbling over how to react to plunging oil prices, OPEC members have finally agreed to a production cut. According to the Nov. 30 deal, the bloc will collectively reduce its output (based on October figures) by 1.2 million barrels per day at the start of next year. In the wake of the announcement, global oil prices jumped by as much as 9 percent. Nevertheless, the agreement is unlikely to keep propping up prices in any significant way in early 2017. The market will still be oversaturated, even despite OPEC's cutbacks and record-high levels of energy supplies in storage.

Of course, the latest deal was designed less to boost prices than to keep them from dipping lower and to encourage a global shortage. Even that, however, will be difficult to fully achieve, despite the bloc's newfound consensus. OPEC states have a history of cheating on their quotas, and this time will be no different. As many of the bloc's members continue to struggle with their own financial challenges, their united front could crack and, in time, crumble. And though oil prices may now increase to between $50 and $60 per barrel, they will rekindle North American shale production if they rise much more, potentially capping any significant recovery in prices.

Under the new agreement, nearly all of OPEC's members will slash their output by 4.5-5.0 percent, sending the bloc's production tumbling from around 33.9 million bpd to 32.5 million bpd. The cartel's bigger Gulf producers will bear the brunt of this reduction; countries such as Libya and Nigeria, however, have been granted exemptions to the new restrictions. Iran even received permission to ramp up its output by 90,000 bpd, bumping its total production to about 3.8 million bpd.

Now that OPEC has internally agreed to rein in its output, it will look beyond its own members for other producers to participate in its arrangement. The bloc hopes to secure enough pledges to shave off an extra 600,000 bpd among non-OPEC countries. Russia, the world's largest oil producer, has already gotten on board, promising to scale back its output by 300,000 bpd. Oman, which produces some 900,000 bpd, has also vowed to cut about 40,000-50,000 bpd. The cartel plans to talk with other producers in Doha on Dec. 9 to try to gin up support for its cause, and it has held similar discussions with Kazakhstan, Azerbaijan, Mexico and Brazil before. It remains to be seen, however, whether these countries will actually follow OPEC's lead.

Under the new agreement, nearly all of OPEC's members will slash their output by 4.5-5.0 percent, sending the bloc's production tumbling from around 33.9 million bpd to 32.5 million bpd. The cartel's bigger Gulf producers will bear the brunt of this reduction; countries such as Libya and Nigeria, however, have been granted exemptions to the new restrictions. Iran even received permission to ramp up its output by 90,000 bpd, bumping its total production to about 3.8 million bpd.

Now that OPEC has internally agreed to rein in its output, it will look beyond its own members for other producers to participate in its arrangement. The bloc hopes to secure enough pledges to shave off an extra 600,000 bpd among non-OPEC countries. Russia, the world's largest oil producer, has already gotten on board, promising to scale back its output by 300,000 bpd. Oman, which produces some 900,000 bpd, has also vowed to cut about 40,000-50,000 bpd. The cartel plans to talk with other producers in Doha on Dec. 9 to try to gin up support for its cause, and it has held similar discussions with Kazakhstan, Azerbaijan, Mexico and Brazil before. It remains to be seen, however, whether these countries will actually follow OPEC's lead.

A History of Weak Enforcement

Getting outside buy-in, however, is not even the main issue. Even if OPEC is successful in finding new partners, it will have trouble making good on its own promises. Rampant cheating has hampered every bargain the bloc has struck, and this deal will encounter the same problem as its signatories try to skirt their agreed-upon quotas. The majority of the world's oil producers have come under increasing financial strain over the past two years, and some are facing other weighty challenges such as the Islamic State's rise. For many, reducing production levels will deal a direct and heavy blow to their financial and political stability.

By the end of the year, each country party to the agreement will have to figure out how best to divvy up its cutbacks at home. This will be fairly simple for countries whose national oil companies hold a monopoly on oil production, such as Saudi Arabia or Kuwait. It will be far more difficult, however, for states like Algeria or Angola that rely on international oil companies for their output, or for countries like Russia whose private and semi-private companies are entangled in national politics.

Regardless of the strategy each country settles on, Saudi Arabia has worked to ensure that the agreement's participants stick to their end of the deal. Riyadh pushed OPEC members to agree to using secondary production figures — more reliable measurements made by six independent agencies, rather than the countries themselves — to determine the quotas and whether states are meeting them. The bloc also established a monitoring committee comprising Venezuela, Kuwait and Algeria.

Venezuela, for its part, has a great deal to gain from seeing the cuts through. Its state-owned oil and natural gas firm, Petroleos de Venezuela (PDVSA), is in dire financial straits. Reducing the glut in the global oil supply could ease the strain on the company, which brings in nearly all of the country's foreign earnings. On the other hand, trimming output is also risky for Venezuela, particularly if other countries renege on their own pledges to pare down production. At a time when Venezuelan output is declining and PDVSA is inching toward default, every bit of revenue counts. With few alternatives available, Caracas has an incentive to try to ensure the OPEC agreement's success in spite of the danger it brings. Venezuela will therefore try to stick to its quota, at least at first. But over time, as a PDVSA default becomes more and more likely, President Nicolas Maduro's government may feel it has no choice but to ratchet its production back up to keep the company afloat and preserve its hold on power.

Iraq will have trouble meeting its obligations as well. Of OPEC's biggest producers, Iraq was likely the least satisfied by the terms of the recent agreement. After Baghdad spent most of October lobbying for the use of government statistics over secondary figures, the bloc chose to use the latter to set its production ceilings. Iraq's bid to be exempted from the cuts because of its war with the Islamic State likewise failed. Instead, Baghdad will have to make the same reductions, percentage-wise, as other OPEC members — amounting to the second-largest cut by volume in the bloc. This will no doubt become a contentious issue at home: Baghdad will probably insist that the Kurdistan Regional Government (KRG) shoulder some of the burden, but in reality there is little the Iraqi government could do to clamp down on the autonomous region's output. Moreover, the KRG has no representation in OPEC, and it has given no indication that it intends to abide by the new deal. That will not stop Baghdad from trying to share the cutback with the KRG, as well as with Kirkuk and southern Iraq, given the drain low oil prices and persistent conflict have put on its coffers. Should Arbil push back against Baghdad's request, it would also give Iraq an excuse for failing to uphold its end of OPEC's bargain.

Participants outside OPEC may not fare much better. Russia, for instance, is eager for oil prices to rebound. The country has been mired in a recession for the past two years, thanks to oil prices that continue to hover around $45 per barrel, and its 2017 budget will be painfully tight. But the Kremlin has yet to reveal how it will distribute its promised cutbacks among its energy companies. Russian oil giant Rosneft has refused to comply with the quotas, preferring to leave them to its competitors, such as LUKoil, to implement instead. Given the recent friction between Rosneft chief Igor Sechin and the Kremlin, it is unclear whether President Vladimir Putin will pick another fight with the company by demanding that it shoulder a portion of the reduction. Perhaps even more important, the output of several other major oil producers in Russia has risen in the past few months and is on track to keep climbing next year. None of these firms will be pleased with the idea of reversing their recent gains.

At Best, a Temporary Fix

Even if cheating cannot be avoided, OPEC's agreement could be enough to make a sizable dent in the global oversupply of oil, even if it is backed only by the Gulf states and Oman. A more permanent uptick in prices, however, would probably still be elusive. The world's oil stockpiles are filled to the brim: The amount of commercial crude in storage in Organization for Economic Cooperation and Development countries can alone cover nearly two months of these states' total demand, and China and India continue to add to their own stashes. It would take a shortage lasting several quarters — if not longer — to siphon off the extra supplies. What the deal could do, however, is trigger that shortage earlier than it might otherwise have occurred, perhaps even by late next year.

Meanwhile, although it is not growing as quickly as it once was, North American shale production has rebounded in recent months. In November alone, U.S. output is estimated to have risen by about 200,000 bpd and is expected to continue its gradual ascent should the OPEC deal fail. For several of the largest U.S. shale producers in Texas and Oklahoma, breakeven costs have dropped as low as $40 per barrel. Though bringing this output online will take time, from a logistical and technical standpoint, the potential resources shale has to offer will act as a cap on how high oil prices can rise.

So far, OPEC's agreement is intended to last for only six months. In May, the bloc will reconvene to assess whether an extension is needed. As of now, no one — including OPEC — knows for certain how much influence its cuts will have on oil prices, or how quickly and to what extent U.S. shale production will come back online. Should prices fail to rise enough to appease the bloc's smaller producers, such as Venezuela, they may call for members to abandon the deal altogether. (A dramatic increase in U.S. output could have the same effect.) But if prices nudge up and stay around $50 per barrel or more, OPEC's larger producers might be willing to keep the cutbacks in place — despite their inability to fundamentally reshape the dynamics of the market or solve the problem of low oil prices.     

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