After Sunday's latest meeting between OPEC and non-OPEC countries in Vienna, energy ministers struck an optimistic note regarding the recent agreement to cut oil output as a committee set to monitor compliance with the deal meets for the first time. Oil producers said they are in "total agreement" on the mechanism for monitoring pledged output cuts, Kuwait Oil Minister Essam Al-Marzouk told reporters after the committee ended its meeting in Vienna.
"I am satisfied, I am optimistic and, as I said, the markets are on their way to rebalance and it's happening," Saudi energy minister Khalid al-Falih said. He added that compliance with the agreement, which calls for cuts to begin this month, had been "fantastic", he said adding that "based on everything I know, I think it’s been one of the best agreements we’ve had for a long time.” The issue, however, is that what everyone else knows is largely sourced from word of mouth statements, at least until the first official reports of monthly production emerge, validating his optimism.
As a reminder, under the Vienna deal struck last December between OPEC and non-OPEC nations, producers agreed to lower production by nearly 1.8 million barrels per day (bpd) aiming to ease a global glut that has weighed on oil prices for more than two years.
Following Falih's claim last week that 1.5 million bpd in production had already been taken out of the market, on Sunday the Saudi energy minister added that "usually non-OPEC would raise their production to compensate for voluntary cuts by OPEC. Now, we are seeing voluntary cuts by both sides." Saudi Arabia, has already exceeded its target with an output reduction of more than 500,000 barrels a day, Al-Falih said, while Algeria and Kuwait have also cut to levels beyond their targets, according to ministers from those nations. Other OPEC members such as Iraq and Venezuela have not yet reached their quotas but say they are more than half-way there.
Al-Falih then predicted that "the other 300,000 bpd, for all I know, is still happening," and hoped for 100 percent compliance in February. Full compliance could take global oil inventories back close to their five-year average by mid-2017, lowering oil in storage by around 300 million barrels, Falih said.
Still, despite the elated promises of cooperation, it still remains unclear just how monitoring of compliance would take place. According to Reuters, Kuwaiti oil minister Essam Al-Marzouq, who chairs the five-member compliance committee, said it would examine how to best monitor compliance and what level of compliance would be acceptable. The other members of the committee represent Algeria, Venezuela, Russia and Oman.
In other words, faith in "compliance" still remains largely a function of trust that OPEC is telling the truth, which in light of historic precedent, when numerous OPEC members complied with initial cut agreements only to defect shortly thereafter, can be a major leap of faith. Indeed, as Bloomberg notes, OPEC has often flouted its own target as member nations quietly tried to gain market share at their peers' expense.
Venezuela's new oil minister, Nelson Martinez said his country has achieved more than half of its planned 95,000 bpd cut, although again there was no way to verify.
"[There are] no surprises so far in terms of demand or supply from other sources so there is no reason for us to suddenly come in January and say we need a bigger reduction or a longer period," he said.
The biggest wildcard remains Russia. It Energy Minister Alexander Novak on Sunday said he was satisfied with the level of compliance shown. Russia has cut its oil output by around 100,000 bpd, Novak told Russia's TASS news agency. Novak added Russian oil production has averaged around 11.15 million bpd this month. In his opening speech to the Vienna meeting, Novak said many countries had lowered their oil output by more than they had agreed to and added that Russia was lowering its production ahead of schedule.
He told reporters that oil output cuts had been positive for markets, adding it was too early to talk about extending the output-reduction deal beyond the planned six months but that remained an option. "Every one sees that the agreements on oil production cuts have already have a positive effect on oil markets. The market has become more stable and predictable."
“We are starting to see a shift in the momentum and the emergence of more bullish sentiment on the market,” Kuwait’s Oil Minister Essam Al-Marzouk said at the start of the monitoring committee’s first official meeting. “These are all encouraging signs that we are on the right track.”
Meanwhile, Saudi Arabia is reportedly producing slightly below 10 million bpd and has informed buyers of Saudi crude of substantial cuts scheduled for next month, he said.
How (non) compliance will be evaluated?
With January not yet complete, Bloomberg reports that the committee will focus mostly on how to assess compliance rather than produce any new data, said one person. As outlined in OPEC’s initial agreement, monthly production data known as “secondary sources” compiled by analysts in the group’s secretariat will be the principal tool for judging whether members are complying with the deal, said three people. Those figures don’t cover non-members such as Russia.
The committee currently has no plans to use external agencies, such as consultants that track oil exports by monitoring tanker movements, to verify that countries are implementing the pledged supply curbs, said three people familiar with the matter. It will meet every month, the Kuwaiti oil minister said. Additionally, the OPEC committee said it would not need export data, and will instead only focus on output data.
“Evaluation of conformity to the respective country production adjustment will be based on production data only,” according to OPEC statement on group’s website. OPEC will present a report with monthly production data to Joint OPEC-Non-OPEC Ministerial Monitoring Committee, known as JMMC, on 17th of each month; report also to include non-OPEC producers’ oil liquid output. Furthermore, the monitoring committee would meet next on March 17, then for 3rd time in May before OPEC gathers that month; with the March meeting said to be in Kuwait.
Each of the 5 member countries comprising JMMC to nominate one technical contact person to form Joint Technical Committee (JTC), which will also include OPEC presidency.
These export obfuscations - the real variable in OPEC compliance - suggests that beneath the thin veneer of deal "compliance", the underlying production dynamics may end up being far different from the promised 1.8mm, if not greater, reduction.
But the clearest indication that non-compliance will be a major hurdle was a statement by the Russian energy minister Alexander Novak who told reporters that violators to the output cut agreement will not be penalized. Which means that without negative reinforcement, compliance may work as long as prices are rising offsetting volume losses, but the moments prices slip expect the agreement to be quickly violated by one or all member states.
“We started to trust each other better, which is just as important as the market re-balancing,” Russia’s Novak said. “One year ago not many believed in the success of this initiative.”
That said, when we check back one year from today, the skepticism of the "many" will be justified. Here's why.
Why Only A Six Month Deal?
As OPEC has claimed before, there’s no indication that the cuts will need to be extended beyond the initial six-month term, Algerian Energy Minister Noureddine Boutarfa said in an interview, echoing comments from his Saudi counterpart earlier this week. “If we really comply by 80 to 90 percent, it may not be necessary to continue,” Boutarfa said. “We aren’t excluding it, but signals are positive.”
But why just six months? As Bloomberg's Julian Lee writes overnight, "that seems a very quick and painless solution to an oversupply problem that has bedeviled the oil market for the past two years, brought several producers to the brink of collapse and tipped others over it."
We now may have the answer. As Lee adds, "the latest numbers from the Joint Organisations Data Initiative offer a different, and compelling, narrative" from the widely accepted one, namely that "brimming supply had created financial difficulties for the kingdom, and also complicated the forthcoming IPO of a small part of Saudi Aramco."
This is what happened:
It turns out that, as the deal was being thrashed out, Saudi Arabia was enjoying a 35-year high in total oil exports. One big factor was a huge drop in the amount of oil the country needs to burn to generate electricity. The punishing Saudi summers boost demand for electricity -- mostly to run air-conditioners -- to a level that previously required vast amounts of oil-fired generating capacity to be brought into use. The direct burning of crude oil in power stations would roughly double to about 900,000 barrels a day at the height of the season.
Saudi oil usage has dropped as natural gas replaces around a third of what it uses for power generation.
But that changed last year. The start-up of the Wasit gas plant allowed the kingdom to slash the use of crude in power generation by as much as a third -- freeing that oil up for export. In addition, the kingdom cut fuel subsidies, pushing down oil consumption by 2 percent year-on-year in the first eleven months of 2016. That's the first dip since at least 2003, when JODI records begin.
As a result, Saudi Arabia was left with "an embarrassment of riches as the OPEC negotiations were underway last year." So, unless it cut output, it would start flooding the market during the first half of 2017. Conveniently, t he stars were aligned for it to solve the problem by persuading others to share the burden in a way that has not been seen since the financial crisis of 2008, while at the same time restoring its credentials as a team player within OPEC.
"This new read on the Saudis' motivations for agreeing to the deal has the benefit of explaining why Al-Falih is looking for a six-month time line and why the kingdom has been prepared to make such a deep cut in its production. Its surplus will have disappeared by that time, at which point it can start to boost production again in order to get exports back to the level it wants to maintain."
Lee's conclusion: "Such a move could easily be the catalyst for the whole deal to fall apart by June." Which, in turn, would explain why OPEC is repeatedly pointing out the "6 month" bogey as a successful deal deadline, after which OPEC members wil go their separate ways once again, pumping to the max. However, there's no way the global backlog of inventory will be dealt with at that time.
Ultimately, "this seems a situation designed to antagonize the rest of the group and create a raft of bad feeling. If maintaining exports is more important to Saudi Arabia than balancing the market, then so is a willingness to back out on a hard-won deal that took the kingdom and its partners a lot of political capital to achieve."
In short, enjoy the OPEC "deal", with minimum surveillance, virtually no compliance markers and zero penalties for violators: the production cut "deal" relying entirely on "trust" between OPEC members, is anything but.
For now, however, oil will trade with each and every optimistic headline out of OPEC, likely pushing the price to a level where the recent surge in US shale production becomes a flood - recall on Friday Baker Hughes reported that the US oil rig count soared by 29, the most since April 2013...
... and threatens to cut deeply into OPEC's own production levels, guaranteeing that the collapse of the OPEC "deal" is just a matter of time.