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Last chance agreement for OPEC?

12 april 2016, 16:23

We may be wrong in believing that there is any urgency in securing an agreement in Doha next April 17th. The outcome of this meeting is irrelevant, the price of the barrel of oil will not re-establish itself immediately nor sufficiently to balance out the public finances of the vast majority of oil-producing countries. Although the price of the barrel has dropped significantly since mid-2014, broadly it still remains above its long-term average price. From 1861 to today, the current average price of a barrel is around $33.90. Historical analysis allows us to conclude that the anomaly is not the current period but the one of 2011-2014. Returns on oil have not been constant since the first industrial revolution.

To have an agreement, there needs to be a convergence of interests, which hasn't been achieved yet. Iran and Iraq have been engaged in regaining market share. Without surprise, the monthly production of Iran increased by 13% compared to June 2014 and by 32% for Iraq over the same period. It clearly shows they are not ready for a production freeze. In the short term, the market is focussing on Iran but, in the much longer term, it is the increase in Iraqi production which creates most risk on the supply side. Two countries are indisputably bearing the costs of the strategy to control the market launched by Saudi Arabia and the other countries of the Gulf Cooperation Council: Venezuela and Algeria. In both cases, the oil industry was unable to adapt to the fall in prices. Therefore, the monthly oil production fell by 0.3% in Venezuela and by 6.7% in Algeria compared to June 2014. Both these countries are on a knife edge. They are both likely to resort to exceptional medium term financial measures (currency devaluation, price freeze, capital controls) as well as to international aid on the even longer term.

In a context of long-term low barrel prices, the urgency for producing countries can be sum up in two points. Firstly, the price of a barrel must cover the cost of production, which is currently the case, including for Venezuela where it is amongst the highest, at $23.50 a barrel. Secondly, an equilibrium oil price needs to be found in order to allow these countries to transition economically in the least unfavourable conditions. This process has already started. The OPEC members have integrated the need to diversify their revenue sources, to sell assets for those who can, or to resort to international loans in an advantageously low interest rate environment. Considering the adaptive capacity of the Gulf states and the national strategies inherent to Iran and Iraq, the cartel has no obligation to obtain an agreement at any price in the short term.

Three scenarios are possible in Doha:

- no agreement at all. In this hypothetical case, the price of the barrel could fall rapidly to around $30-$33 on the very short term after the announcement, before bouncing back in the medium term to its trading range over the last few weeks, between $35 and $40. This is a very likely scenario considering the information currently available and the market fundamentals. Doha would be, in the end, a non-event for investors. A global agreement would be reported to next June by the OPEC;

- a minimal agreement which would consist in a production freeze for several oil producer countries under the same plan as per the February agreement. Such an outcome would not resolve the problem of oversupply in the market and the downward pressure on prices would continue. Furthermore, the question of compliance with the terms of the agreement by all the stakeholders would be on the table. In fact, Russia interpreted fairly liberally the production freeze decision in February in which it had been involved. Thus, in March, Russian production continued to increase, culminating in a peak since the end of the Soviet era, of 10.91 million barrels a day. Finally, a minimal agreement is clearly not in the interest of Saudi Arabia as it would consist in giving a blank check to Iran for taking back shares of the market;

- a global agreement including Iran. It could include a special clause that would give an additional delay for Tehran to reach a higher level of oil production before a total freeze. This is the least worst-case scenario for all the producing countries, but it implies that strong pressure is applied to Iran to make it accept. This is the only hypothetical case where the price of the barrel could shift to the target price of $50 established by OPEC in the medium term. Such an agreement would not be easy to implement and it would involve a strict control over market prices by OPEC. Indeed, the organization cannot afford the price to get back to $50-60 per barrel because, at this level, the US shale oil producers are once again profitable and they could flood the market with their supply.  

Even in the case of a global agreement, OPEC will not be capable of stemming the unavoidable emergence of the dual threat of Iraqi production and shale oil for which operation costs are falling rapidly, thanks to innovative technologies. The OPEC members are aware that they can only gain time and they must take advantage of this to diversify their economy, and, at times, reform their ill-adapted social systems to the era of low oil prices.

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