Saudi Arabia’s Oil “Proposal” – Here’s What’s Really Going On

Yesterday, Russian Energy Minister Alexander Novak claimed that Saudi Arabia had proposed a 5% cut in oil production.

That set the oil price rollercoaster off and running, with crude prices shooting up to levels not seen in a month.

As of close of oil trade yesterday (2:30 pm Eastern), West Texas Intermediate (WTI) – the New York benchmark oil rate – was up 7.7% since Monday, with the first three-day price rise of the year.

There is only one problem.

My contacts in OPEC and Saudi Arabia tell me that things look very different behind the scenes.

Here’s what’s really going on…

Saudi Arabia Can Weather Low Oil Prices… For a While

Despite the Russian Energy Minister’s claims, my contacts in Saudi Arabia and OPEC categorically state that no offer to cut production was made.

At least not formally.

Welcome to what is becoming the latest geopolitical game of smoke and mirrors.

It’s déjà vu all over again.

These last two days remind me of the meetings I had recently in Abu Dhabi. Once again, an apparent move to engineer a reduction in oil production is scuttled by the recalcitrance of one of the main players.

As I have written on several recent occasions, the attempt to forge a workable cut in production is a very dicey one. The Saudis continue to maintain a posture of defending market share by driving other producers to cut production first.

In theory, Riyadh can do this because it has the cheapest production costs – rumored to be less than $12 a barrel on average. This has always been difficult to substantiate given that basic data has been unavailable since the Saudis took over Aramco in 1979.

The trial balloon floated recently – the idea that the Saudi government may be interested in privatizing a portion of what is now Saudi Aramco – is intriguing in this respect. It would at last allow outside folks to have access to some real reserve, cost, and profit figures.

Still, it’s clear that the Saudis can weather a low price of oil better than anybody else.

Even so, they have been forced to reenter the global financial markets for the first time in years, while significantly revising the budget by cutting expenses and introducing new taxes.

Only Kuwait and the United Arab Emirates (UAE) are similarly situated financially, although both are feeling the strain of $30 a barrel oil.

Things look very different for the remaining OPEC members…

OPEC Can’t Agree On What to Do

All other OPEC members – especially Venezuela, Nigeria, Libya, Algeria, and Ecuador – have long since become budgetary basket cases. So it should come as no surprise that they are pushing for Saudi Arabia and OPEC to coordinate a cut in oil production.

A production cut, if it could be set in place and it stuck, would raise the price of oil and improve revenue flow. But some of the damage already endured will be hard to overcome.

And then there is Iran and Iraq. Both are members of OPEC but have not had a monthly quota assigned by the cartel in decades. Iran is eager to move as much new production into the export pipeline as possible now that Western sanctions have ended.

Yet, as I have noted here in Oil & Energy Investor on several occasions, field integrity, support, and infrastructure problems are endemic in Iran.

An initial rise of 500,000 barrels a day from the country is possible but without significant (and immediate) Western finance and expertise, such a rise is not sustainable.

Then there is the contract outside companies have to use inside Iran.

Since the 1979 Revolution and Constitution, foreign entities are not allowed to own land or raw materials in Iran. That makes any move to the more appealing approaches of partnerships or joint venture agreements impossible.

Instead, the current buyback accords are brutal and time-consuming to negotiate. They provide no incentive to improve on agreed production levels, provide no compensation if market or technical factors move in the wrong direction, and specifically prevent companies from placing any portion of reserves on their books.

The outside company pays for everything and then is reimbursed in kind (with a portion of the oil realized).

Things aren’t much better in Iraq…

Iraq’s Oil Production is in Danger

When it comes to Iraq, despite much optimism from Baghdad, the official production targets are simply unattainable. Concerns over ISIS in the north and rising Shiite political opposition (supported by neighboring Iran) in the south place a political cloud over sustained production.

Here as well there are contract problems.

Iraq uses service agreements whereby outside companies are paid for each barrel produced beyond a contracted level. Once again, there is little incentive in improving production since the return is insufficient.

There are also infrastructure problems here, especially in treatment and pipeline systems.

Political infighting in Baghdad has prevented finalization of essential legislation on oil production and profit sharing between regions. The nation’s basic oil law has been in limbo for more than a decade.

Combined with the continuing acrimony between the central government and the semi-autonomous Kurdistan Regional Government (KRG) in the north, foreign companies are holding back.

What we have, then, is a situation where OPEC can’t even police itself internally, as cartel members oversell in the current low price environment to realize any possible revenues but end up depressing prices further.

That’s even before the uncertain addition of Iran and Iraq are figured in.

All of which puts into question the ability of Saudi Arabia or OPEC to entice production cuts with primary outside producers.

Instead, two non-OPEC countries are now of primary importance…

U.S. Oil Production Cannot Be Centrally Controlled

With OPEC unable to do much, the U.S. and Russia are now paramount.

There is no question that the dive in prices has mothballed more expensive, deeper, vertical drilled, and fracked projects in the American market.

Nonetheless, improvements in technology and better efficiency have resulted in overall production being resilient, despite significant cuts in forward capital investment and rig counts. By mid-year we will probably see a net reduction of no more than 300,000 barrels a day – about 3.3%.

The problem faced by the Saudis in forcing a cut in U.S production is the nature of the domestic U.S. market. There are no national oil companies, no centralized way to impact nationwide drilling policy.

In addition, as U.S. exports begin flowing to the international market for the first time in over four decades, the rising competition is increasing concern both within and without OPEC.

Russia, meanwhile, is another matter entirely…

Russia Needs an Oil Deal… Fast

In Russia, the export of oil and natural gas is the lifeblood of the central budget and a matter over which the Kremlin has direct control.

As such, the current price for oil is causing a major national budgetary and financial crisis. The ruble is once again crashing against foreign “hard” currencies and the prices of products in the street are skyrocketing.

In other words, Russia has a more immediate need than the U.S. for a cross-border production accord. And the Kremlin has the means to implement an accord nationally.

As a result, an agreement between Riyadh and Moscow remains the only way to allow the Saudis to claim victory, take their football home, and allow prices to rise.

[Editor’s Note: Kent recently discussed Russia’s financial mess, and how you can profit, in detail here.]

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