Tiles that fit together
The unprecedented commitment of countries such as Saudi Arabia and Russia, and the unexpected U.S. U-turn against hydrocarbons lead to anticipate a "sealing" of the recent oil agreements

After more than two years of out-of-control supply, since January 1, 2017, a large group of countries decided to reduce their oil production. They amounted to 24: 13 OPEC and 11 non-OPEC. The countries involved accounted for 55% of global production, with 52 million barrels per day, 34 from OPEC and 18 from non-OPEC countries. Never before had such an extensive effort been seen; moreover, never before had excess supply been at this level, with prices falling from $110 per barrel, at the beginning of 2014, to less than $30 per barrel in January 2016. At the beginning of 2017, prices returned to $55, partly due to a high degree of compliance with the commitments made on production cuts. The OPEC agreement, signed on November 30, 2016, provides for a ceiling of 32.5 million barrels per day, approximately 1.2 million bbl/d less compared with the record peaks of 33.7 in November 2016. The agreement relating to the non-OPEC side, announced on December 10, 2016, provides for a further reduction of another 0.6 million bbl/d, bringing the total reduction to 1.8 million bbl/d. A similar reduction in supply, if confirmed throughout the entire first quarter of 2017, had only been observed back in 1999, when the long bullish cycle began which, except for the temporary interruption in 2009, lasted until 2014. Since then, a series of events, combined with the clash between Saudi Arabia and Iran, triggered a sharp increase in supply well beyond that which the demand, despite slowing down, was able to absorb. What can be seen, in the increasingly complex situation of the oil market, is a short supply in the coming years that prepares the ground for the future bullish cycle, which aims at the $100 per barrel threshold. In the last 50 years, demand has never stopped growing, with an average rate of 1.2-1.5 million bbl/d per year. In the last 30 years, consumption has increased by a third, totaling an extra 36 million bbl/d. The greater slowdown or speed with which supply follows the consumption trend determines the underlying performance of prices. With the rapid rise in production, stocks rise and prices fall; the opposite occurs with demand, which rises, supported by supply. Cyclically, these periods alternate and result in substantial price fluctuations. At the beginning of 2017, with a sharp fall in production and with a demand that continues to grow steadily, like diesel engine, the start of a new cycle is expected. However, certain elements combine to provide greater balance: on the one hand, U.S. production and, on the other hand, technological innovations, especially the electric car.

An agreement with no historical precedents

Such an extended agreement, involving all major players in the Middle East, has not been recorded since 1998. Fundamental, as usual, was the rapprochement between Saudi Arabia and Iran, following a year of grueling negotiations. In the context of uncertainty that characterizes oil, a dominant rule is that when relations between two countries improve, prices rise, while if they fight, as occurred between 2014 and 2016, prices fall. The threat of Iran’s full return to the market prompted the Saudis to flood the market with surplus production. Riyadh did not like the fact that the Americans and Iranians had restored good relations, as this represents a threat for its leadership ambitions over the entire Middle East. Obama’s disengagement from Iraq, in 2011, had left an empty space, which was then filled with internal instability and Isis. To try to solve the problem, Washington enlisted the help of Tehran, whose intervention, as a counterpart, led to the request to lift sanctions on nuclear power. Threatened, and even slightly disappointed by the Americans, Saudi Arabia suddenly decided to boost its production to defend its market share, ahead of the potential return of Iranian production to the market, which could have increased the current 2.5 to 4 million bbl/d, a share reached prior to the sanctions. Such an action was justified in an attempt to put a stop to the costlier American production from fracking, or that which, beyond politics, threatens the Saudi market share. The price collapse that followed was of an unexpected intensity, even for the Saudis themselves, who hoped to exert more pressure on the Iranians and to achieve sharper decline in U.S. production. After two years, however, they had to accept what now seems obvious, that is, that the Iranians, after the lifting of the sanctions, could go back to producing 4 million barrels per day, the threshold on which its production has been substantially stable for 20 years. All the other OPEC members, those "external" to Middle Eastern discord, expressed a desperate need for an agreement. Venezuela and Algeria, countries traditionally exposed to crude oil price fluctuations, have seen their economies dramatically worsen and, inevitably, their internal political instability dramatically grow. For months, to no avail, they have put pressure on Iran and Saudi Arabia to reach an agreement. The degree of compliance of OPEC shares was very high at the beginning of 2017; a rigor rarely observed in the past, suggesting that many members of the cartel had suffered from the previous situation. Two major countries, Nigeria and Libya, were exempted from the terms of the agreement, because their production is much lower than normal levels due to internal political conditions. These two countries are expected to increase their production this year, in the best-case scenario, by 0.5 million bbl/d, a growth that will not create significant problems for the market. As of 1985, when the first of a long series of crude oil price collapses occurred, many attempts were made by non-OPEC countries to define common initiatives to control production, without, however, achieving significant results. In this case, the support given to the agreement by a large group of non-OPEC countries, led by Russia, the true element reinforcing recent dynamics, seems to be more stable and determined. The 11 non-OPEC countries are committed to reducing production by another 0.55 million bbl/d, of which 0.3 by Moscow. In the previous, failed, attempt in 2001, Russia had promised a cut of 30,000 bbl/d, ten times less than that proposed under the latest agreement and, despite this, it did not intend to comply with it. Moscow has now established its leadership, while the promised cut appears to be easier, since it meets the decline already underway in many oil fields due to the lack of new investments that should have been made over the past two years and that have been delayed due to financial difficulties. Unlike OPEC, the degree of compliance with the non-OPEC agreement appears lowers, since Russia, in order to reduce its production, needs more time. Technically, its oil fields do not provide for the possibility of immediate re-adjustments, with a slowdown in extraction levels.

Wind of change in Moscow and Washington

Political and military activism in Moscow and the Middle East has also affected oil diplomacy, given that its economy, already heavily tested by the sanctions of 2014, depends, like no other, on the performance of the barrel. Russia is the second largest oil exporter, with 5 million bbl/d, behind just Saudi Arabia, but has long been the top gas exporter, with approximately 200 billion cubic meters per year, equal to over 3 million barrels of oil equivalent per day. Gas prices targeted at Europe and Asia, towards which Russian exports are intended, are still set according to the trend in oil prices. Throughout 2016, Moscow had encouraged Saudi Arabia to accept that Iran could go back to producing its pre-sanction levels, while Russia received heartfelt invitations from Venezuela and Algeria for better coordination. Since February 2016, Russia has attended three meeting to coordinate a reduction in output and, finally, a strong rapprochement came at the summit of the end of September, on the sidelines of the World Energy Forum in Algiers, which then paved the way to the end-of-year agreements. For thirty years, as soon as Moscow raised the issue of oil prices, fear rose among many parties of a possible expansion of OPEC; currently, however, Russia’s new direction is being underestimated. The element that will mostly contribute to applying the brake to the bullish rise of the barrel will be U.S. production, which was expected to collapse with the fall in prices in 2014, but which, instead, declined less, by approximately 0.9 million bbl/d, to 12.3 million bbl/d; at the beginning of 2017, production itself showed signs of a slight recovery. If prices go back, in a stable manner, to above $60, production itself will grow again in a more sustained manner. The cost-reduction process, launched in 2014, has never stopped; in 2012, in Texas, between $70 and $90 were recorded, while at the end of 2016, in the best areas, they stood at between $40 and $60. In the Permian Basin, from Dallas to Odessa, in Texas, production continued to grow, reserves were revised upwards, the search for new solutions to save on water, on pipes, on the rental of drills, on chemical compounds, and on geoseismic analyses, never ceased. New solutions are constantly applied in the search for better geological stratification in which to apply fracking. There are thousands of companies working in this sector in the Odessa and Midland area alone, another hundred thousand in the rest of the United States, and there is abundant scope for cost improvement. The sector grew, almost out of nowhere, between 2006 and 2014, and now, for the contingent of geologists, chemists, truck drivers, metal workers experienced in valves and pipes, it would be difficult to find alternative employment. The U.S. banking system has always helped, with very low interest rates and with a certain ease, to fund this activity, but it never witnessed the re-entry of resources. Optimism, even in difficult times, as in the best tradition of the American frontier, has never abandoned these pioneers of the global oil industry. Had the former President been a Republican, the greater support of the oil industry in the ‘50s could have been attributed to him but, paradoxically, he was Democrat who tried to impose stricter environmental rules. Thanks to increased production, and in conjunction with a slight decrease in domestic consumption, the U.S.’s dependence on oil imports decreased from a maximum of 60% in 2005 to a minimum of 24% in 2015, a figure not seen since the ’80s and which represents a success for Obama. While the former occupant of the White House had not done much to support the boom in domestic production, new Republican President Trump will do everything to encourage it. To lead the EPA (Environmental Protection Agency), he appointed Scott Pruitt, Attorney General of Oklahoma, the oil state par excellence, famous for having led lawsuits against environmental regulation, imposed by faraway Washington. Gone are the fears that the EPA could restrict fracking activities which, objectively, have a heavy impact on the environment. Had Clinton been elected, there would certainly have been tightening of environmental constraints that would have increased production costs. Trump has so much confidence in oil that he chose, as head of diplomacy, Texan Rex Tillerson, CEO of ExxonMobil, the largest oil company in the world, based in Irvin, Texas, with solid roots in the Middle East. Tillerson has a deep understanding of all complexities in the areas and, at the same time, has been a skilled negotiator with Putin’s Russia. Despite strong criticism from the opposition, his presence, on the one hand, reassures Saudi Arabia as regards relations with Iran and, on the other hand, ensures a frank dialogue with Putin, to limit political instability.

Hopes resting on the demand

Global oil demand, also in 2017, will reach a new record high of 97.8 bbl/g, confirming an underlying trend that sees an increase by 1.2-1.5 million barrels per day every year, more or less the equivalent of Algeria’s production or Germany’s demand. In this way, the 100-million-barrels per day threshold is approaching, deemed difficult to achieve 15 years ago, due to lack of reserves. Compared with the ’70s, a period of profound crisis, before that of 1973 and later that of 1979, demand has increased by 35 million barrels per day and, despite attempts to reduce it, does not show signs of decreasing. Oil remains the top source for covering the global energy demand, with 35%, a figure that gives way only slightly to gas and renewable sources. In recent years, the debate regarding the oil peak has shifted from that of production, which would have been caused by the exhaustion of reserves, to that of demand, which will be reached in a few years, thanks to alternative sources and electric cars. If we were to focus on the whirlwind of information on the Internet, which creates a kind of virtual science, a future climate cataclysm caused by fossil fuels, including oil, seems certain, while its abandonment, thanks to the affirmation of the electric car, is just a few years away. In reality, while we wait for more concrete evidence on climate change, oil demand will continue to rise, while population growth, globalization, improved living conditions for billions of peoples will all result in an increased need for mobility. This will be achieved mainly through internal combustion vehicles that use large amounts of energy that only oil derivatives, such as gasoline and diesel, can guarantee. Oil consumption to 2040 will continue to rise towards the threshold of 115 million barrels per day, a figure that, in 2016, seemed very far off, as in the ’80s, when it seemed excessive to speak of the 100 million barrels per day that will be reached in a couple of years. Meanwhile, however, it will take time for the huge stocks accumulated in the last two years to be reabsorbed. The commercial stocks of the OECD countries, i.e., those that have the greatest impact on the price dynamics, have reached a record level of over 3 billion barrels, while, in terms of consumption prospects, these have reached 66 days. With the production cuts made at the beginning of the year by OPEC and non-OPEC countries, these levels will immediately begin to decline, with different expectations for prices.

The new Saudi paradigm and the future

Saudi Arabia remains the main instigator of the global oil market, as the top country in terms of reserves, production, exports and unused production capacity. In January 2017, its production recorded a drop of over 0.5 million barrels per day, a cut not seen for over a decade and that reveals the Saudi determination to lead the price recovery. The director is the new oil minister, Khalid Al-Falih, the former president of Saudi Aramco, a company that has always produced the best state officials. His appointment, in April 2016, slightly downsized the ambitions of the young prince, Mohammed bin Salman, the 32-year-old son of King Salman, who ascended the throne in January 2015, when the oil collapse had just started. The young prince, a kind of economy minister, during some recent statements, in January 2016, explained his "Vision 2030," based on which the country’s economy will gradually be liberated from its dependence on oil exports. He is well aware of the problems of a parasitic system made up of millions of people who pretend to work on state salaries that are derived from Aramco’s oil exports. Moreover, as someone who is always connected to the network, he is convinced that its oil will soon become nothing other than black rock with no value, once that, in a few years, the electric car will have replaced internal combustion engines. The oil minister, being older and more experienced, knows very well that this will take a long time and that oil will still be in demand for much longer. The OPEC agreement of November 30, 2016, that of December 10, 2016 of the non-OPEC group led by Russia, the high degree of compliance with the agreements at the start of 2017, and Saudi Arabia’s commitment, are all reasons that suggest that the market is heading towards a new cycle, characterized by a demand that is growing more than supply. A decade ago, the strong growth in Chinese demand was followed by a growth in supply and this caused prices to rise to $140 per barrel in July 2008. We have almost forgotten the ease with which those values were reached, which are now unthinkable. It is true that strong support comes from the degeneration of finance which, even now, has not completely gone, and that some new help will come from Trump. Currently, things are a little different. Demand is rising less, the Chinese economy has slowed down, India is unable to maintain the same rates of growth, internal combustion engines, which run on gasoline or diesel, are showing continuous improvements in efficiency, despite the electric traction making progress, but still in a context of hybrid cars. In terms of supply, the United States, with rising prices, is increasing production, but still by limited volumes that are unavailable on the international market. The production cuts at the beginning of 2017 suggest that a price increase is highly likely, but what is important is that this does not occur with shock increases, the ancient evil of this market, and that OPEC knows, this time, how to better govern the change.