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Takeaway: Saudis Court Russia Amid Rising Concern About Surging US Production & Market Share

Editor's Note: Below is an abridged research note by Hedgeye Energy Policy analyst Joe McMonigle. If you would like access to his institutional research email sales@hedgeye.com.

Oil Bromance Split As Russia Resists Extending OPEC+ Cuts Through H2 2019 - Russian oil cartoon April 2019

As if OPEC needed any more bearish sentiment signals, Russian energy officials, and President Putin himself, have now suggested in recent days that Russia does not support extending the OPEC+ production cuts for another six months when the current deal expires at the end of June.

The decision to extend the oil production cuts for another six months will be the key decision at OPEC’s upcoming June 26-27 meeting in Vienna.

In March, we wrote a note about Russian resistance to continuing the OPEC+ cuts and said “we think Russia will increasingly be a reluctant partner in future cuts.”

The oil market is now asking whether the Saudi-Russia oil bromance is over.

Saudi energy minister Khalid al-Falih will be in Russia on Friday through Monday to try to convince Russia to stay the course on cuts.  We expect a full-court-press by al-Falih in his talks with President Putin and Russian Energy Minister Alexander Novak amid the current free-fall in oil prices prompted largely by sentiment and macro signals. 

Russian oil companies were never in favor of the cuts and are pushing the government to exit the deal as it has forced them to delay new production projects.  One company suggested it will start new projects regardless and seek compensation from the government if there is another cut extension in June.

If it were up to the oil companies, Russia would walk away from the cut deal.

The wildcard is President Putin who will likely receive a phone call by King Salman or Crown Prince Mohammed Bin Salman in the days leading up to the OPEC meeting in late June.

Putin enjoys the international spotlight of being a key player in oil markets with the Saudis but Russia is also increasingly concerned about losing market share to surging US production that has surpassed Russia as the world’s biggest producer.

Complicating matters is the contamination in Russia’s 1 million barrels per day (b/d) Druzhba pipeline that has sent Russia’s production down to 10.87 million b/d, a low not seen since 2016.  A silver lining of the pipeline situation is that Russia has finally started to meet his compliance commitment under the December OPEC+ cut agreement.

But when the pipeline issue is resolved, Russia will want to hike production amid fears of losing market share.  Moreover, Minister Novak reiterated on Thursday that Russia supports prices in $60-65 per barrel range. This position is at odds with the Saudi and OPEC price preference for the $75 to $80 range. President Putin in comments today acknowledged the divergent views on a desired oil price.

Minister al-Falih said last week that the OPEC consensus is to extend the cuts at the upcoming late June meeting. We agree that it may be the OPEC consensus but Russia is part of the non-OPEC group, and is at a minimum, today not committed to the extension.

Even though Russia compliance has been weak and only committed to a small 280,000 b/d cut, the Saudis view Russian participation as critical for market sentiment.

A Russian exit from the OPEC cuts would be very bearish for oil prices even if OPEC itself continues the cuts.  OPEC would need not just a cut extension but also an increase in production cuts to offset the impact sentiment from a Russian exit.

We think it’s possible that Russia stays in the OPEC+ alliance for future oil market cooperation but just indicates that it cannot comply due to special circumstances of the pipeline issue.  Another possible alternative scenario is that the Saudis get Russia support for the cut extension with the full private approval that Russia will hike production.

Macro factors combined with recent increases in US crude inventories and rising light crude production are responsible for the latest downturn in oil prices. In our view, we think fundamentals are strong for a tight oil market, especially as refiners come back online after a longer than normal seasonal maintenance and growing geopolitical risks.

But as always, effective OPEC messaging at the June meeting will be critical for market sentiment.  Iran, and now Russia, are two challenges that OPEC must overcome to turn the oil market narrative and reverse the price decline.