For the past two weeks recurring flashing red headlines of an agreement, or at least a meeting, between Russia and Saudi Arabia - the world's two largest oil producers - have led to aggressive short-covering rallies in oil on just as recurring hopes that the Saudi strategy of flooding the market with excess supply (by its own calculations as much as 3 million barrels daily) adopted during the 2014 Thanksgiving Day OPEC massacre, will come to an end.
Tomorrow this endless "headline hockey" will come to an end, following what is now a confirmed "secret" meeting between the two oil superpowers when, as Bloomberg reports, Saudi Arabia’s oil minister will meet with his Russian counterpart in Doha on Tuesday "to discuss the oil market."
According to Bloomberg, Ali al-Naimi, the most senior oil official of the world’s biggest crude exporter, will speak with Russia’s Alexander Novak in the Qatari capital, "according to the person, who asked not to be identified because the talks are private." The person didn’t say what the agenda of the meeting will be, which will also be attended by the kingdom’s fellow OPEC member Venezuela. The energy ministries of Russia and Saudi Arabia declined to comment.
Going into the meeting, one thing is certain: over the past 15 months Saudi Arabia has never once indicated any interest in curtailing production: after all, that would go against its unstated directive of putting marginal oil producers, read US shale companies, out of business:
Saudi Arabia has insisted that it won’t reduce production to tackle the global oil glut unless major producers outside the Organization of Petroleum Exporting Countries co-operate. While Novak has said he could consider output cuts if other producers joined in, Igor Sechin, chief executive officer of the country’s largest oil company Rosneft OJSC, said last week he would defend traditional markets and expressed doubts over coordinated action.
To be sure, the Saudis have felt the pain from collapsing oil prices resulting in a record budget deficit, accelerating austerity at home, and the alleged liquidation of Saudi FX reserves, including European financial stocks and potentially US and other sovereign bonds. The market has gone as far as pricing in a very high probability of a Saudi Riyal devaluation as expressed by the currency's forward market as observed here previously.
It is this "pain" that has made the market doubt Saudi's steadfastness in sticking to its excess production plan: "the slightest signs of an accord have roiled oil markets. West Texas Intermediate futures rallied 12 percent on Feb. 12, the biggest surge since 2009, after the United Arab Emirates reiterated OPEC’s long-held position that the group is prepared to engage with non-members."
But even if the Saudis are receptive to some token compromise, Russia itself may be unable to cut production. As Bloomberg writes in a separate piece, "neither a recession nor a collapse in revenue has yet been enough to convince Russian President Vladimir Putin that it’s time to join with OPEC in cutting oil output to boost prices. His reasons may be pragmatic rather than political."
As Russia’s oil minister meets his Saudi Arabian counterpart in Doha on Tuesday, the world’s second-largest crude producer faces numerous obstacles in cooperating on such a deal even if Putin decides it’s in the national interest. Reducing the flow of crude might damage Russia’s fields and pipelines, require expensive new storage tanks or simply take too long.
To be sure, the jawboning on Russia's side has been quite loud: energy minister Alexander Novak has said he could consider reductions if other producers joined in. Igor Sechin, chief executive officer of the country’s largest oil company Rosneft OJSC and a close Putin ally, said last week in London that coordination would be difficult because no major producer seems willing to pare output.
Still, many are skeptical that just like in the case of Mario Draghi, talk will escalate into actions: "The history of relations with OPEC suggests that Russian companies are not keen to cut production," James Henderson, an oil and gas industry analyst at the Oxford Institute for Energy Studies, said by phone. "There are certain practical difficulties, and the companies would rather somebody else did that, and they could benefit once the price goes up."
Here are some of the all too practical challenges facing Russia should it indeed plan to cut production:
In Siberia, Russia’s main oil province, winter temperatures can go below minus 40 degrees Celsius (minus 40 Fahrenheit). That’s a challenge for anyone thinking of turning off the taps.
The oil and gas that flows from wells always contains water, so once pumping stops, pipes may freeze, Mikhail Pshenitsyn, who has worked for more than 10 years in the Russian oil industry, said by e-mail. The problem goes away in summer, but there’s still the risk of a long-term reduction in output because a halted reservoir can become polluted with salts and residues, he said. Production from a shut-in well might never be restored in full, Maxim Nechaev, director for Russia at consulting firm IHS Inc., said by phone.
Furthermore, Russia is running into a problem that is facing both the U.S. and China: running out of land-based storage space:
Russia could reduce exports to global markets without cutting production simply by putting more crude into long-term storage. Trouble is, the country has too few facilities.
The bulk of onshore storage capacity in Russia is owned by pipeline company AK Transneft OAO and already in full use to ensure steady flows to refineries and ports, Vladimir Feigin, head of the Moscow-based Institute for Energy and Finance, said by phone. Building the massive new reservoirs required to store a significant proportion of production for an extended period would cost billions of dollars and couldn’t be done quickly, he said.
Additionally, unlike the U.S., Russia has little offshore storage: while crude can be stored in vessels moored just offshore, Russia has "only seven tankers -- four products and three crude -- in floating storage,” Antonia Mitsana, marketing manager at London-based Drewry Maritime Advisors, said by e-mail. Their total capacity is just over 643,000 metric tons, according to Drewry, or about 0.1 percent of the nation’s production last year."
And while chartering foreign vessels to store significantly more oil could be done, it would be very expensive. Freight rates are up in the short-term tanker market and ships in limited supply, Mitsana said. Also, keep in minda that this is a Russia which is now considering dumping diamonds in the market just to sporadically fill holes in its budget.
Ironically, when taking Russia's deteriorating financial situation in consideration, Russia actually has an incentive to boost not reduce production: the government is seeking ways to increase revenues from the energy industry, which generates more than 40 percent of the national budget. Finance Minister Anton Siluanov suggested cutting the price threshold for oil exempt from production taxes to $7.50 a barrel from $15, according to a report from RIA Novosti, a domestic news agency. More production therefore would mean more taxes; less production would lead to an immediate hit to the Russian budget.
Also, as Bloomberg notes, changing the tax regime is a slower process than the “emergency” response Venezuela is seeking. "Usually such big tax changes would come into force from January of the next year" if they were included in the annual draft budget due in October, Sergei Likhachev, associate director for tax practice at Moscow-based law firm Goltsblat BLP, said by phone.
Finally, as a reminder, after his recently concluded meetings in Moscow and Tehran, Venezuelan Oil Minister Eulogio del Pino said six nations were ready to meet and discuss output cuts. The problem is that as the above demonstrates, the probability of such an agreement including Russia remains distant.
"Last year, things didn’t move beyond talks," said IHS’s Nechaev. “I am sure the same is going to happen this year.”
Which means that all that will happen tomorrow is that the biggest short squeeze trigger, the threat of an imminent production cut and recurring flashing headlines hinting at this, will be eliminated. At that point the market can focus on the real underlying dynamics: not only excess supply but clearly slowing global demand...
... and U.S. oil land storage, which as we and the market have been warning, is about to overflow.