1. Most important: for Saudi Arabia, it's too soon for a production freeze. The market is still oversupplied with record huge crude inventories. Therefore, in the Saudi’s view, more cap-ex cuts and production declines are needed to bring the market into balance, otherwise the last two years of pain - costing the Saudi’s about $100 billion a year - were for naught.
In 2014 when the Saudi’s declined to intervene with production cuts to limit the price slide, the market share strategy was launched. Saudi Arabia realizes they are no longer the only actors affecting oil markets, especially in light of surging US shale production. If the Saudi’s cut production to stabilize prices, they lose market share.
The strategy called for a period of low prices that would force production declines in high cost production (shale & off-shore mega projects). After one year, the Saudi’s, and most everyone else for that matter, were surprised at the resiliency of US shale. So the Saudi’s were determined to ride out another year of low prices to starve non-OPEC production. What followed were cap-ex cuts two years in a row and a steady decline in US production. According to the IEA, global cap-ex cuts since 2015 are now at $330 billion, and Wood Mackenzie further estimates cap-ex cuts in global upstream of nearly $1 trillion out to 2020. Meanwhile, US production has steadily declined about one million b/d from a high of 9.5 million b/d n April 2015.
But crude stocks are still at record levels – a stark reality that is putting a damper on the market-is-balancing party. The most recent EIA data for the week ending September 9 reported crude stocks were at 510.8 million barrels - up 55 million barrels this year and 100 million barrels above the five-year average.
The Saudi strategy has worked. The IEA said this week that Saudi Arabia has ousted the US as the world’s top producer. However, price signals this summer near $50 have slowed declining production. The IEA changed its previous forecast that the market was balancing at year-end and now says non-OPEC production will rise in the first half of 2017. Rising non-OPEC production is anti-freeze to the Saudi’s.
So a freeze now would just throw a lifeline to US shale. In our view it is still too soon for any change in OPEC production policy. Saudi Arabia is more nervous about oil at $50 than $40 because they know it keeps US shale alive. The barometer for any new change in OPEC production policy is declining US production and Saudi Arabia wants to see more of it.
2. Iran is just nine months into ramping up exports and regaining market share, and simply can't agree to any limits on production now. Since nuclear sanctions were lifted in January, Iran has aggressively entered the market share game. As we forecasted in December 2015, Iran has quickly ramped up production and exports in excess of 700,000 b/d. Two separate independent assessments now peg Iranian exports at one million b/d of crude on the global market.
Iranian production has significant implications for oil markets for two reasons: 1) All that new Iranian crude has just replaced the one million b/d decline in US production; and 2) Surging Iranian exports has launched a market share proxy war with Saudi Arabia as both producers go after Asian and European customers. The Saudi’s say their record July production of 10.69 million b/d was needed because “customers asked for it.”
Some analysts say that Iranian production is plateauing, and therefore, the timing might be right for a freeze. We don’t necessary disagree that production may have peaked. We said back in December that we thought Iran could reach about one million b/d on their own but to get back to pre-sanctions levels they would need western capital and technology. Nevertheless, arguments that Iranian production is plateauing will fall on deaf ears in Tehran for purposes of the freeze. Iran intends to get back to pre-sanctions production levels at all costs.
For its part, Iran has said it cannot participate in a freeze until “it returns to the market share before the sanctions.”
3. Iran & Saudi Arabia geopolitical tensions are at sky high levels and don't bode well for a productive meeting in Algeria. Syria has always been a source of intense disagreement between Iran and Saudi Arabia and continues to be so. Iran supports the Assad regime while Saudi Arabia supports the rebels and wants Assad replaced. However, two other recent flashpoints make further cooperation on any front highly unlikely.
One is in Iraq, where an Iranian supported militia plotted to assassinate the Saudi Ambassador to Iraq. Media reports say that one of the plotters confessed that an Iranian official developed and oversaw execution of the plan. You may recall that in 2011 Iran was also tied to a failed plot to assassinate the Saudi Ambassador to Washington. The Ambassador at the time, Adel al-Jubeir, is now the Saudi Foreign Minister and the Kingdom’s “bad cop” when it comes to Iran.
The other flashpoint is the ongoing war in Yemen where Iran is equipping the Houthi rebels with weapons. An Iranian-supplied rocket was recently fired from Yemen into Saudi Arabia killing two young girls in the Saudi border town of Najran. About 500 Saudi civilians have been killed in border fighting with Yemen. Another rocket also recently hit near a Saudi Aramco facility in southwestern Saudi Arabia setting fire to a power relay station.
With the increased rocket attacks by Yemen into Saudi Arabia and the failed Iranian assassination plot in Iraq, we don't have the makings of a productive meeting in September.
4. No Iran exemption – a freeze is not a freeze without Iran. President Putin told Bloomberg recently that it would be “unfair” for Iran to be required to participate in a freeze so soon after nuclear sanctions were lifted. Putin’s comments, plus a newly formed Saudi-Russia energy working group, have led many observers to believe a freeze agreement can be reached in Algiers that exempts Iran from participation.
We see an Iran exemption has a non-starter for Saudi Arabia. The long-standing Saudi policy is that it will agree to a freeze as long as all producers, OPEC and major non-OPEC, participate as well. Setting aside the non-OPEC producers participation requirement, Saudi Arabia is intently focused on Iranian production. And the policy comes from the top. In April Deputy Crown Prince Mohammed bin Salman (MBS) said “without a doubt” Iran must participate in the freeze. In MBS’ own words: “If all countries including Iran, Russia, Venezuela, OPEC countries and all main producers decide to freeze production, we will be among them." He also added this warning: "If there is anyone that decides to raise their production, then we will not reject any opportunity that knocks on our door.” Fast forward to July, when the Saudi’s hit record production of 10.69 million b/d and August looking just as robust. We take MBS at his word: no freeze without Iran.
5. Saudi shift in tone should not be seen as a shift in policy. Public relations have been increasingly playing an important role in oil markets. At his first OPEC meeting in May, new Saudi Energy Minister Khalid al-Falih was the first to appear in Vienna. In contrast, the Iranian minister was the last to arrive walking into his Vienna hotel about midnight the night before the OPEC meeting.
Coming off the failed Doha freeze meeting in April that Saudi Arabia was blamed for scuttling and which Iran didn’t even attend, Saudi Arabia is trying to appear more cooperative in dealing with fellow OPEC members and in the process paint Iran as the bad uncooperative actor.
After oil markets took a pounding in July, Minister al-Falih made comments in early August about cooperating with other OPEC members "if necessary."
Iran has also said it would attend the International Energy Forum (IEF) in Algeria. We think one of the real drivers for Iran to attend is to meet potential crude customers attending the IEF but also to try to appear cooperative with the latest freeze talk.
September is historically a challenging month for oil prices with lower demand and refinery transitions. Therefore, we expect to see more “unnamed sources” in news articles talking up the prospects for a production freeze agreement at the end of the month in Algeria. The Saudi’s will play along since they want to be viewed constructively by other OPEC members. But it’s a shift in tone not in policy. Iran cannot participate in a production freeze, and therefore, Saudi Arabia emphatically will not agree.