Takeaway: Saudis playing ball with Russia to keep in the fold on market coordination but plan on modest & symbolic amount - far less than 1 mbd.

Oil prices declined sharply last week on comments made by the Russian and Saudi energy ministers in St. Petersburg about potentially adding new supply to the market.

News reports and market consensus last week treated the comments as a done deal to significantly increase production to address $80 oil prices when OPEC and Russia meets on June 22.  But it is far from a done deal, and in our view, any added production would be symbolic and stay within the OPEC production agreement cap.

Another news report today signaled dissention within OPEC about any move to add production. We are less concerned about any OPEC dissention and more focused on the Saudi/Russia dynamic.

Saudi Arabia is unfazed by $80 oil and correctly believes that the physical oil market is adequately supplied. But Russia, under internal pressure from domestic oil companies who have been clamoring for months to an end to the OPEC production cut deal, is talking up the idea of adding production.

Oil prices went south after Russia floated the big shinny object of a 1 million barrels a day (b/d) production boost that would bust the OPEC production cut deal. However, Saudi Arabia is on the opposite end of this spectrum.

The Saudis don’t want any daylight between them and the Russian on oil matters so they are playing ball with Russia to keep them in the fold on continued oil market coordination.  

While the market seems to have priced in a 1 million b/d supply boost number, it is not what the Saudis have in mind.  Instead, they want to bring along Russia to their view of no or modest increase in production.

The meeting of gulf producers this weekend in Kuwait is designed to enlist help to convince Russia on a lower number or even no increase.

The Saudis view this as a political problem  - keeping Russia in the fold; and responding to complaints about higher prices from Trump/India/IEA - but don't see higher prices as a problem.

So what’s the path forward?

We have seen a pattern now before every OPEC meeting and even bilateral meetings between Russia and Saudi Arabia: Russia openly talks about ending the production cut deal or reassessing the market need for production caps going into the meeting, but in the end Saudi Arabia persuades Russia to maintain the deal. Much of this is posturing for Russian oil companies. As a result, we think Russia will come closer to the Saudi position at the June 22 meeting.

Saudi Arabia can add another 100,000 b/d and still stay under the OPEC deal cap. They would normally increase production during summer months to meet higher domestic energy demand and may use as a convenient contribution to adding production as a political solution.  We think the Saudis would accept a 100,000 b/d match in production from Russia.  A handful of others can add another 100,000 b/d (Kazaks already signaled higher production was coming).  

Our view of the number of "added production" is closer to 300,000 b/d than 1 million b/d and would still keep the OPEC production cut deal in place for rest of the year.  This would be bullish for oil prices.

Another scenario we are hearing about is a potential reallocation of the production limit caps to offset the decline in Venezuela production. Under the OPEC deal Venezuela’s allocation is about 2 million b/d but as of April they were producing only 1.4 million b/d – a deficit of about 600,000 b/d that has accelerated the decline in global crude stocks into the 5-year average range. The reallocation of Venezuela declines would be spread among all the members of the production cut deal but still retain the overall top line ceiling of 32.5 million b/d.  This is still in very early stages and unclear if it will gain traction as Saudi Arabia prefers a much lower number.

However, we are still bullish on oil prices regardless of added OPEC/Russia production of 300,000 b/d or 600,000 b/d.  We continue to see a healthy strong demand; likely another 500,000 b/d production decline in Venezuela this year; and another 500,000 to 1 million b/d in declines from Iran sanctions.

There will continue to be headline risk leading up to the June 22 OPEC meeting (we will attend and report from Vienna). Certainly a lot can change in the months ahead and a wild card here would be Russia walking out on the OPEC deal but we think this is very unlikely. Saudi Arabia would rather negotiate on a production increase number than lose Russia as a partner in oil market coordination.

NOTE: Join Hedgeye for a lunch briefing with former OPEC President and Algerian energy minister Chakib Khelil in Boston and New York on June 11 and 12 respectively. Contact for more information and to reserve your seat.