By Fuad Shahbazov
December 19, 2016
On November 30, OPEC secured a cut in oil production from 33.8 million barrels a day (b/d) to 32.5 million b/d. As cheap oil from the global oil glut created budgetary shortfalls in oil-producing countries across the world, the severe economic challenges facing petro-states led to this special agreement, which is OPEC’s first to cut oil output since 2008, and the first time that non-OPEC Russia will back the cartel’s cuts to prop up prices since 2001. This unexpected decision sparked a huge rally in the price of both oil and gasoline. Given the state of regional turmoil from Syria to Yemen, however, it is legitimate to ask if politics will cause the agreement to fall apart in 2017.
The agreement was designed to reduce the production in global oil markets. It was successful despite pessimistic forecasts leading up to last month’s meeting in Vienna. After all, OPEC’s April 2016 meeting, held in Doha, ended with no deal, as member countries did not reach any consensus on the level of oil production. Iran participated in private talks led by Qatar, which currently holds the OPEC presidency, but Qatar failed to get Tehran on board because Iran argued it needed to regain market share lost during years of international economic sanctions. Whereas some OPEC members such as Ecuador and Venezuela favored cutting oil production, OPEC’s September 2016 meeting, held in Algeria, also failed to achieve this goal with Libya and Nigeria appearing reluctant to cut their oil production.
Nevertheless, Saudi Arabia’s offer to Tehran to freeze oil production just before the Vienna meeting began last month fueled optimism. It allowed Iran to increase its production by 90,000 b/d, a significant victory for the Islamic Republic as it tries to rebuild its economy amid the partial lifting of sanctions following the historic passage and implementation of the Joint Comprehensive Plan of Action (JCPOA).
It is important to understand Riyadh’s decisions within the context of the Kingdom’s experience with low oil prices in the early 1980s, when the Saudis cut their own oil production to stabilize prices while other countries continued to increase their production. This policy was a disaster for Riyadh. Aramco had to make cuts that threatened the company’s long-term growth. Finally, in 1986, OPEC met to try and reinstate quotas. This time around, Saudi Energy Minister Khalid al-Falih said ahead of the meeting that the Kingdom was prepared to accept “a big hit” on production to strike a deal. Saudi Arabia believed that even had talks over oil production failed in Vienna, oil prices would rise by itself due to the energy market’s price determination.
However, nearly all member countries voted in favor of the oil cut deal, Saudis were keen to impose the agreement conditions on Tehran. The strained negotiations were held with officials in Tehran, as Saudi Arabia’s oil minister and his Iranian counterpart, Bijan Zanganeh, were engaged in a game of brinkmanship that at times seemed likely to doom this meeting.
First, Tehran offered to freeze oil production at level 3.975 million b/d, while Saudi Arabia insisted on remaining at its current production, 3.7 million b/d. The Kingdom surprisingly agreed to reduce its own oil production to 500,000 b/d. Riyadh joined the consensus due to the deepening economic crisis stemming from low oil prices that triggered its huge deficit. For the first time in more than three decades, the kingdom turned to debt markets to ease the financial squeeze after oil prices fell below USD 50. Riyadh has reacted to the fall in oil prices by cutting government spending, burning through foreign reserves, and raising debt to finance Saudi Arabia’s steepest budget deficits since the 1990s.
Moreover, the Kingdom attempts to boost non-oil revenue to reduce its dependence from oil industry. The government in Riyadh plans to modernize and diversify the Kingdom’s economy through the ambitious reform plan, Vision 2030, which aims to move Saudi Arabia beyond its dependence on oil. A higher oil price would stabilize the domestic market and improve Riyadh’s ability to invest. An irony of Vision 2030 is that to boost the country’s economy and diversify it away from oil, the Kingdom needs to sell oil. Moreover, the economic agenda calls for the partial-privatization of state-owned Aramco, valuing the world’s largest energy firm at as much as USD 2.5 trillion. The move seeks to boost employment and diversify the domestic market. However, there is skepticism about whether the Kingdom is ready for radical changes. Nevertheless, the Aramco IPO would allow the government to invest proceeds and future dividends into non-oil sectors.
Although Saudi Arabia and Iran have managed to reach consensus on oil production level, the Iranian state broadcaster’s newspaper Jam-e Jam covered the OPEC Vienna deal with the headline, “The Defeat of Riyadh’s Oil Diplomacy”. Although member countries agreed on oil production levels in Vienna, Riyadh could unilaterally suspend the deal over production quotas, as the Kingdom did in November 2014. Therefore, three member countries – Qatar, Algeria, and Venezuela - were named as moderator countries to avoid any confrontations between Riyadh and Tehran.
In global energy markets, even small changes can affect oil prices. A day before the meeting in Vienna, Brent oil prices fell from USD 49 to USD 47 per barrel due to sceptical forecasts, while after several hours the agreement has been reached, Brent prices rose up to USD 52 per barrel. The Kingdom understands that the failure of current negotiations would negatively impact Brent oil prices. Therefore, Saudi Arabia’s choice to cut oil production and join the consensus was highly rational. The other Gulf Cooperation Council (GCC) members in OPEC (Kuwait, UAE, and Qatar) also embraced Riyadh’s line.
Of course, it is necessary to factor into consideration the cuts in production from non-OPEC countries such as Russia (300,000 b/d), Mexico (100,000 b/d), Azerbaijan (35,000 b/d), Oman (40,000 b.d), which they agreed to earlier this month. Nevertheless, the most important actor in this group of non-OPEC members is unquestionably Russia. Sources maintain that Russian president Vladimir Putin was directly involved in backstage negotiations with Saudi Prince Mohammad bin Salman (MbS) and Iran’s Supreme Leader Ayatollah Ali Khamenei. It started when Putin met MbS in September on the side lines of a G20 gathering in China. The two agreed to cooperate to help oil markets clear a glut that had more than halved oil prices since 2014, plummeting government revenues in Russia and Saudi Arabia. In early December, oil prices shot up ten percent, reaching USD 53 a barrel. Undoubtedly, Russia’s growing influence in the Middle East gave Moscow wide appeal to affect not only energy policies but also energy markets. However, the agreement reached in Vienna late last month still needs much diplomacy to be finalized. Considering the ongoing wars in Syria and Yemen, where Saudi Arabia and Iran are opposing stakeholders and fierce rivals, it is easy to imagine regional crises undermining the prospects for any long-awaited compromise between Riyadh and Tehran.
Riyadh’s all out efforts to prop up oil prices by reducing oil production without having an agreement with Russia did not pay off for the Kingdom. Apparently, Saudi Arabia did succeed in wringing a rare concession from non-OPEC member Russia. Officials in Moscow said that they would move to cut 300,000 b/d. Saudi Arabia is keen to take the lion’s share by keeping output high and fight for market share around the world. Under these circumstances, Saudi Arabia needs oil price about USD 65 to USD 70 a barrel to meet budgetary requirements for 2016. Considering the fact that Saudi Arabia ended 2015 with a record budget deficit of USD 98 billion, it will not be possible to cover all financial losses until the end of 2016.
It remains unclear whether all involved parties will abide by all terms and conditions. Iran will likely continue seeking new investors for its petroleum industry, which will fuel tension with Riyadh. Given the exacerbation of geo-sectarian tensions in the region, particularly with respect to Iranian-backed Syrian Arab Army re-capturing Aleppo earlier this month and the Houthis’ attacks in southern Saudi Arabia from Yemen, there is a high risk that regional politics will lead to the agreement’s unraveling.
Fuad Shahbazov, based in Baku, Azerbaijan, is a foreign affairs analyst at Wikistrat Inc.