Saudi Arabia reaches a compromise with Russia

Ministers of the Oraganisation of Petroleum Exporting Countries (OPEC) and their allies have agreed to extend their production pact all the way to the end of 2018 but with a review in June that will take into account market conditions and progress towards rebalancing.

The outcome represents a successful compromise between de facto OPEC leader Saudi Arabia (which wanted to announce an extension throughout 2018) and non-OPEC heavyweight Russia (which wanted to avoid giving such a long commitment).

The decision was in line with traders’ expectations and there has been little change in either outright crude prices or calendar spreads since the decision was announced on Thursday.

As a practical matter, it makes little difference whether the decision is described as a nine-month extension from the end of March, when the current cuts were scheduled to expire; or a three-month extension from March to June with the option of extending them until December 2018.

The compromise allows ministers to signal a resolve to do whatever it takes to rebalance the market (a Saudi priority) while preserving flexibility to adapt to changing market conditions (a Russian one).

Critically, it recognises the oil market has already made significant progress towards rebalancing but also that there is uncertainty about how quickly the process will be completed

Saudi Arabia’s oil minister, Khalid Al Falih, said on Thursday the excess of OECD oil stocks over the five-year average had already shrunk from 280 million barrels in May to just 140 million in October.

Crude oil in floating storage has fallen by 50 million barrels since June, and products stocks are already down to their five-year average.

Both Brent and WTI have flipped from contango into backwardation for the first time since 2014, Falih noted, indicating the market’s move towards a more balanced condition.

“Market stability has improved and the sentiment is generally upbeat. The rebalancing trend has accelerated and inventories are generally on a declining trend,” Falih concluded.

Rebalancing is now more than half-way completed, he said, but the market is moving towards the seasonally weak, low-demand period through the second quarter of 2018.

For Saudi Arabia, therefore, the emphasis was on maintaining production discipline to get the job finished and avoid a renewed slump in oil prices. “We must stay the course,” Falih urged his colleagues.

Russia, however, has begun to worry about what comes next once rebalancing has been achieved.

Brent prices are already trading well near $64 per barrel, the average for the whole of the last cycle from 1998 to 2016. In real terms, the average Brent price in 2017 will be in line with the median since 1973.

The Brent spread is now well into the upper half of its full cycle range, and the backwardation is firmly established, which points to a market that is no longer significantly oversupplied.

If OECD stocks were to decline to the five-year average, the market would almost certainly feel uncomfortably tight, given the enormous growth in oil consumption since 2012.

Oil prices and calendar spreads would rise further, and the shift could be very rapid. Rising prices would encourage a sharp increase in drilling and production from the US shale sector.

As Falih acknowledged, the pace of rebalancing has accelerated, which is normal cyclical behaviour, because supply-demand-stocks-prices dynamics in the oil market are highly non-linear.

If OPEC waits before adjusting production until stocks have fallen close to the five-year average and the market has fully rebalanced, it will risk a spike in both prices and spreads to the upside.

Prices and spreads overshot following both the previous OPEC-led efforts at oil market rebalancing after the slumps of 1998/99 and 2008/09.

For Saudi Arabia, which needs higher oil revenues to fund its ambitious transformation programme, and higher prices to secure a favourable price for the Aramco share listing, overshooting might not be a problem.

But Russia needs the extra revenue less and is more worried about losing market share in Europe and Asia to competition from rising US shale oil exports.

The compromise allows both sides to claim a measure of victory, with Saudi Arabia getting a nine-month extension and Russia obtaining an explicit commitment to review after three months.

The bottom line is that OPEC and its allies are committed to maintaining current production levels through the end of June 2018.

The pact may be extended until the end of 2018, with or without modifications, depending on the level of stocks and prices when the review is conducted in the middle of next year.