Oil in 2016: The return of Opec

After a two-year experiment with free markets, the pain of low oil prices forced the world’s biggest producers to join forces in 2016 and tackle a global supply glut.

Saudi Arabia-led Opec and non-member countries, primarily Russia, agreed after months of discussion and back channel diplomacy to cut production for the first time since the global financial crisis.

Prices look set to end the year in the mid-$50s — about double the 13-year intraday low of $27.10 a barrel Brent touched in January — with hedge funds more bullish on oil than they have even been. A growing number of analysts and investors believe the cuts will reduce stockpiles, bringing supply and demand into balance more quickly next year.

An arduous year-long process saw Opec return to the world stage and geopolitics again loom large in oil market policymaking.

“2016 has shown us the return of Opec,” says Jason Bordoff at the Center on Global Energy Policy at Columbia University. “In a sharp break from the last two years members worked together, brought non-Opec countries on board, and their efforts culminated in action that was more pronounced and serious than most expected.”

This reflected the pain inflicted by low oil prices. The budgets of resource-rich nations had been shredded while international oil companies were cutting billions of dollars of investment in future production in a desperate attempt to remain profitable.

Even Saudi Arabia, which led the cartel’s push in November 2014 to keep the taps open and pressure high-cost rivals, softened its hawkish tone. It challenged other big oil producers to join it in curbing production, saying it would back actions to shore up prices if they were mirrored by rivals both inside and outside the cartel, particularly Russia.

The scene was thus set for the first Opec production cut since 2008 and the first collaboration with Russia and other non-members for 15 years. But it was far from clear that a deal would be reached.

As Iran prepared to flood a glutted oil market in January after years under western sanctions, and the International Energy Agency warned the oil market could “drown in oversupply”, Russia’s energy minister Alexander Novak indicated that he was prepared to meet Opec to discuss production caps.

“The first step on the road to recovery is to admit that you have a problem,” says Yasser Elguindi at Medley Global Advisors. “The most significant event in 2016 was Saudi and Russia’s ability to overcome all their regional and political differences and . . . attempt to provide a floor under oil prices.”

In February both countries — the world’s biggest oil exporters — reached a preliminary agreement to freeze their oil output should other big producers join the effort. At the time the kingdom’s former oil minister Ali al-Naimi called it “the beginning of a process” — one that would run until December.

Even as Russia’s public displays of support became more frequent, a deal to curb output still proved elusive.

April talks in Doha on a global deal to freeze output were derailed at the last minute by Saudi Arabia, which demanded the participation of its fierce regional rival Iran. Tehran was not prepared to sign up to a deal while it was focused on boosting production and returning exports to their pre-sanctions levels. Squaring that circle would take time and test the resolve of Opec.

“The way in which they didn’t reach an agreement was significant, suggesting that the Saudi-Iran conflict played a role,” says Mr Bordoff. “A call came from higher up and it reminded us of the role of geopolitics in setting oil policy.”

By the next Opec meeting in June, the cartel remained divided on how to manage the oil market. Saudi Arabia’s newly installed energy minister Khalid al-Falih — a close confidant of the powerful Deputy Crown Prince Mohammed — publicly voiced the need to again “steward the market”.

Paul Horsnell, commodities analyst at Standard Chartered, says Mr Falih shifted the narrative from a production freeze to signalling output cuts. “Saudi Arabia would soon be thinking of output restraint.”

Even as talks continued, Saudi Arabia, its Gulf allies and Iraq ramped up production to record levels. Russia attained a post-Soviet high.

“Opec and Russia succeeded at employing verbal intervention to hold oil prices up, first by talking about a freeze and cuts from record levels, while simultaneously adding a net 1.4m barrels a day of new supply into a glutted oil market,” says Bob McNally at the Rapidan Group, a Washington-based energy consultancy.

It was not until September in Algiers that Opec managed to stitch together a preliminary deal to cut production. Conflict-ridden Libya and Nigeria would be exempt while Iran would be given a special dispensation. “After two-and-a-half years, Opec reached consensus to manage the market,” said Iranian oil minister Bijan Zanganeh at the time.

There was still more work do to, however. It took months to iron out the distribution of cuts, an important but tricky process that involved secret talks and intervention from the highest levels in Russia, Saudi Arabia and Iran.

Keen to assert its influence in the Middle East and see higher oil prices, Moscow said privately it would back a deal, but it needed to see Opec commitments first.

Ultimately there would not have been an agreement unless Saudi Arabia had pushed for one. The need for a higher oil price to sustain social spending and, more importantly, fund Prince Mohammed’s economic transformation plans for the future eventually carried the day.

In return for the kingdom shouldering the bulk of the reductions, Saudi Arabia required a formal limit to Iran’s output, cutbacks from other Opec peers including Iraq, an agreement on how to calculate cuts to ensure compliance and lastly securing the co-operation of Russia. All of its conditions were met, even if Opec had to employ some fancy footwork to make the numbers stack up.

“Opec surprised many in the market by reaching agreement, just as it was increasingly being written off as unable to act collectively,” says Amrita Sen at Energy Aspects. “Although we are not expecting 100 per cent compliance, there should be no doubt that Opec has well and truly returned.”

Anjil Raval, FT