The OPEC+ group of oil producers reached another major agreement on June 6th to cut production. But, unlike their historic and relatively successful agreement in May, the incentives to cheat on production quotas is much greater this time around because prices are much stronger than they were; the ability to punish cheaters remains limited; and the illusion of a return to business-as-usual masks extreme uncertainty in the oil market.
June 8 2020
Scott McKnight
The so-called OPEC+ group of top- and mid-tier oil producers agreed on another round of production cuts, building on the relative success of the historic agreement made over Easter weekend in early April. This most recent agreement, which vows to cut 9.6 million barrels per day (bpd), is just 100,000 bpd short of last month’s historic cuts that came in the wake of the coronavirus pandemic that decimated world oil demand.
But, unlike their relatively successful implementation of the May agreement, there are three factors that challenge the viability of this agreement that weren’t present—or were present in much reduced form—last time around. First, prices are much stronger than they were from late March to mid-May. Second, the ability to ensure compliance to these agreed-upon cuts—and therefore punishing cheaters—remains limited. Third, the lure of a return to normalcy actually covers up extreme uncertainty in the global economy, and by extension, in the global oil market. Each of these factors incentivizes countries and companies to increase production for those outside of OPEC+ as for those within it.
Back from the brink
The collective decision of OPEC+ countries to extend cuts came after a cordial and brief video-conference on Saturday. This contrasts with the abrupt walk-out or multi-day marathon sessions of the March and April meetings respectively. This time the horse-trading was done in the lead-up to the meeting and was no doubt informed by the relatively successful implementation of the last agreement.
But several factors surrounding the last agreement are different this time around. In the last agreement, the catastrophic collapse in oil demand, which according to the EIA amounted to some 29m bpd, or nearly 30% of global oil demand for the month of April, necessitated a collective agreement. During 11 days of March, oil prices plummeted from nearly $50 per barrel to $20, rendering much of the global oil production uneconomical. Since late April, however, the price of Brent crude, a global oil benchmark, has doubled in value to just over $40. This time, however, oil prices have rebounded from their unthinkable lows that prevailed through March and April. However frail and uncertain, increased oil prices greatly influences the challenges of implementing this agreement.
Keeping others in line
With this sharp rebound in oil prices, producers—countries and companies alike—are tempted to increase production. But the OPEC+ group does not really possess a credible mechanism to ensure compliance and enforce the accord its members reach, despite the presence of powerful members like Saudi Arabia and Russia.
For all of the excitement around the sense of unity that led to the historic 9.7m bpd cuts of the last agreement, the reality was that four countries to the agreement didn’t fulfill their promised cuts. Among the cheaters were the familiar faces of Iraq and Nigeria. Iraq in particular has reportedly earned the ire of Saudi Arabia for its unwillingness to make production sacrifices, though Iraq is facing a multifaceted crisis of its own. On top of dealing with the fallout of the Covid-19 pandemic and oil price collapse—a death blow for a government that is 90% dependent on oil revenue for its functioning—the new and fragile government can ill-afford to cut production as it recently came to power as a result of protests in late 2019 as it teeters on the brink of bankruptcy while it also dealing with rebuilding and fighting the remnants of the Islamic State.
These two non-compliers, along with Kazakhstan and Angola, have promised to make up for their shortfalls in the coming months, something that naturally warrants skepticism and especially so given that the oil prices may be stronger than they are when this and the last agreements were reached.
Another challenge to compliance comes from Libya. The civil war there decimated production from 1.2m bpd to a mere 90,000 bpd at the start of 2020, which was disastrous for the country but turned out to be a fortuitous event for other producers who were haggling over their own production cuts. Libya’s production is set to roar back, boosted in part by its largest oilfield coming online in the coming weeks.
OPEC, like its almost four-year-old progeny OPEC+, has long struggled to enforce cuts and punish cheaters. The balancing act or ‘swing producer’ role has inevitably fallen on Saudi Arabia, the largest producer of OPEC and the country with the largest spare capacity. But even Saudi Arabia’s absurd oil abundance is often impotent to the machinations of the organization’s member-states, which instead often leaves Saudi Arabia shouldering the brunt of cuts so as to prop up prices.
Saudi Arabia’s go-to method—perhaps it’s only real method—of enforcing agreements and punishing cheaters has been to wage war on the entire oil market, a tactic it used after Russia refused to go along with cuts in early March. In this most recent oil price war—it has launched several before 2020—Saudi Arabia ramped up production to a historic high of over 12m bpd for some five weeks before a series of tweets, phone calls and high-level consultations brought OPEC+ members to heel and agree to those 9.7m bpd of production cuts over Easter weekend.
Thinking the worst is over doesn’t make it true
The third incentive to increase production is not directly connected to the oil market but rather stems from the widely shared illusion of a return to normalcy in the global economy. There is no shortage of reasons for concern: the possibility of a ‘second wave’ of coronavirus infections and deaths in several or many countries, the likelihood of a global economic recession, a US-China trade war that has no end in sight—any one of these factors could have a big impact on the global oil market. But so far they all seem to have the effect of cancelling out one another.
Prince Abdulaziz bin Salman, Saudi energy minister, believes that ‘we are over the worst’ of the crisis and oil ‘[d]emand is returning’. At the same virtual meeting this past weekend, Alexander Novak, the Russian energy minister, said that the oil market ‘is still in a fragile state and needs support.’ Both can be true at the same time.
In the oil market, this combination of higher oil prices and a collective sense of having moved past the coronavirus pandemic, each likely feeding off the other, likely means companies and countries again ramping up production, which again would put downward pressure on prices and expose this OPEC+ agreement to pressures it hadn’t faced last time around.
