The Vienna Compromise

The Vienna Compromise

Marc-Antoine Eyl-Mazzega
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In June, the alliance of producing countries decided to increase the output of crude oil, against the backdrop of a surge in prices and severe restrictions on imports to Venezuela and Iran, shaken by sanctions and economic difficulties

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During the last OPEC meeting, on June 23, 2018, that gathered members of the organization and their allies (the so-called OPEC+ alliance) notably including Russia, a number of interesting developments have been reached. Unexpected declines in production from Venezuela led to a very large overrun of the production reduction targets set in November 2016 and in a context of robust demand growth, markets got tighter with stock levels down. On the backdrop of a global economic growth projected at over 3.9 percent for 2018 by the International Monetary Fund, oil prices have risen by more than 50 percent in less than a year, reaching $77 per barrel in May 2018. That has the potential to boost U.S. production further and to slow down global oil demand growth. Producers without the ability to raise output and/or that were hit hard by the falling oil prices and had an interest in cashing in as much as possible, wanted to avoid a change in quotas to keep prices up. This included Venezuela, Algeria, Iran and Iraq.

On the other side, Russia and Saudi Arabia were pushing to increase output as both countries can produce more and were seeking to benefit from higher prices ahead of the summer demand increase and to avoid a further rise in prices. The latest OPEC+ agreement is a compromise that makes the U.S., Saudi Arabia and Russia the winners. The elephant in the room in the Vienna negotiations was Donald Trump, and his concerns about high oil prices going into the summer driving season and the November mid-term elections, while U.S. liquids output is on a steady rise, fueling growing exports. The latest agreement will see an increase in output by over 500 kb/d but it is still unclear how this will be done. Russia will be able to boost output by at least 200 kb/d as of this summer, and is on track to be able to raise budgetary spending with no deficit. And this comes just after the introduction in Russia of a major fiscal change that will make the Russian budget even less dependent on oil price fluctuations. De facto, Saudi Arabia, the U.S. and Russia are also winners because they will be able to progressively take market share away from Iran and Venezuela, who will respectively face sanctions coming into force in November and a continued chaotic situation. Iran granted its support to this latest agreement despite strong reluctance as the increase is within the boundaries of the 30 November 2016 agreement. The country’s oil revenues are already starting to be hit by the new wave of American sanctions constraining its crude exports and will be further reduced with a lower oil price. Four questions remain: will China and India continue to buy Iranian oil and to what extent? What will Iran’s geopolitical response be to export limitations? Will the price of oil stabilize or continue rising and put demand levels at risk? Lastly, will producers finally introduce serious economic reforms?

OPEC’s total liquids output  de  facto  only  decreased  by  around  400 kb/d in 2017 versus 2016, due to the surge in output from Libya and Iraq. This also highlights the extent to which the production levels chosen as the baseline for the cut were high. With the return of U.S. sanctions, Iran’s 2.5 million barrels per day (mb/d) liquids exports are expected to decline, but it is expected that China, India, possibly also Russia and others, can find ways to access most of this oil, possibly at some discount. Ensuring strong discipline to respect unilateral U.S. sanctions is not a given. In Venezuela, production has fallen by 700 kb/d to below 1.5 mb/d in the past 18 months and could fall by another 300 kb/d, given the magnitude of its economic and political crisis and the risk of more U.S. sanctions being introduced. Raising OPEC+ output in the second part of 2018 will help avoid accelerating the weakening of OPEC’s market position, which is a serious issue for consideration.

Price growth to rescue the weakest economies

With the exception of the dramatic social and economic crises in Venezuela, leading OPEC+ oil producers have managed to navigate through the storm of lower oil prices. This is because the real stress and strain period only lasted around 16 months, from January 2015 until August 2016, when the price of oil started moving slowly upward. Kazakhstan and Algeria avoided sliding into economic recession but experienced sluggish growth rates. Beyond the chaotic situation in Venezuela, Russia faced the longest and sharpest recession, while Angola, Azerbaijan, Saudi Arabia, Iraq, Iran and Nigeria also went through a year of economic recession and stagnation. Angola’s economic situation worsened dramatically, yet was stabilized by the government. However, no IMF country support program was put in place for any of these oil producers. Had Saudi Arabia pursued its high-output/low-price strategy during one additional year and had Venezuela’s production not collapsed, several regimes would probably have been exposed to social tensions, falling production and unsustainable  budget  deficits,  risking  destabilization. A sustained period of $30/bbl oil would probably have created very serious macroeconomic, social and financial challenges for Algeria and possibly also, Russia, Nigeria, Angola, Azerbaijan and Kazakhstan. Saudi Arabia itself would have struggled to finance its social and military spending. The OPEC+ agreement and Venezuela’s output collapse have certainly set a floor to oil prices, making producers cautiously optimistic that the worst is behind them. For most of these countries, the fall in oil prices and revenues led to currency depreciation or devaluation following costly attempts to defend the exchange rate (with the notable exception of Algeria), a move to floating currencies (Russia, Kazakhstan), rising inflation (due to imported inflation and monetary creation), spending cuts (primarily social or infrastructure spending, but also military outlays), growing state budget deficits, a fall in real incomes, a rise in poverty, lower upstream capital expenditures (with the exception of Russia), a weakened banking sector and weaker sovereign credit ratings. Ultimately, producers did not drastically cut their public spending to avoid economic and social issues, yet decided to run budget deficits, covered by fiscal reserves and recourse to domestic or international bond markets. They also benefited from the currency depreciation, which has softened the impact of falling oil prices, export values and tax revenues. Russia masterminded management of its budget deficit thanks to its Reserve Fund, from which it drew more than $50 billion, as did Algeria, Kazakhstan and Azerbaijan. Yet these countries also tapped into strategic welfare funds aimed at supporting infrastructure investments or pensions for example. Russia’s Reserve Fund was emptied, as was Algeria’s. Azerbaijan and Kazakhstan, by comparison, have managed to limit excessive withdrawals. Saudi Arabia managed to mobilize its large reserves, which are still far from depleted.

The stability of the political system put to the test

No producer has faced collapse, with the exception of Venezuela. It has been confronted with a perfect storm of falling investments, falling production, soaring inflation, insecurity, social uprising, institutional collapse and political turmoil. Despite strong backing from Russia, Cuba and China, the country could not contain the deepening crisis. In the ten countries examined here, only one electoral change occurred which can be related to the fall in oil prices: in Angola, the former President Dos Santos finally left office after 38 years in power and the recent elections brought new persons in charge and reduced the direct influence of the Dos Santos family. It is noteworthy that presidential elections took place in Kazakhstan in 2015 and then in Russia, Azerbaijan, Venezuela in 2018, without any serious challenge to the rulers seeking re-election, although none of these elections were free and fair. With the exception of Venezuela, the current turnaround has been strong. No policy shift has occurred in these countries. Social unrest has taken place here and there, locally in Russia, Kazakhstan, Nigeria, Algeria, and to a larger extent in Iran during the winter of 2017-2018, but under tight government control and with no political impact. Last but not least, in Saudi Arabia, a new leader has risen to power, Crown Prince Mohammed bin Salman. Legitimized by his father, he is young (born in 1985) in a country where 25 percent of the population is less than 15. He displays vision and ambition, but he has also been taking big risks, both internally and externally, with still-uncertain consequences. The resilience of regimes has many explanations. Yet, in Russia, Saudi Arabia, Iran and to some extent Azerbaijan, regimes have used their geopolitical conflicts to strengthen loyalty and their legitimacy.  Russia is involved in wars in Ukraine and Syria, and has engaged in a confrontation with the E.U., NATO and the U.S. Saudi Arabia is involved in a war in Yemen and has been playing up two enemies, Iran and Qatar. Azerbaijan engaged militarily in the Karabach conflict in spring 2016. And Iran was involved in the fight against the ISIS terrorist group in Iraq and is actively engaged in Syria and Lebanon in order to “stabilize the region” and fight terrorism. Regimes have played the geopolitical card in order to underplay, sideline or silence, political or social demands, and have resorted to repressive policies. This may backfire as the middle class, and the poorest can opt for the “voice” option. Yet in many cases, these countries lack a political system, or opposition leaders, to channel political discontent, with opposition forces being marginalized or oppressed.

Iran, Iraq and China in focus

Iran is a special case because it was freed from sanctions when the storm of oil prices came, and benefited from a rapid increase of production and exports by 1 mb/d as of autumn 2015. A major political change had happened in 2013, when Iranians elected a reformer as President, Hassan Rouhani, after years of conservative ruling and economic degradation. After successfully reaching the nuclear deal in 2015, he was re-elected by a stronger majority in the May 2017 presidential elections, in a clear signal that Iranians supported his economic reforms and want change: internal liberalization and external normalization. Supreme leader and all-powerful cleric Ali Khamenei had given his blessing to these changes. Yet President Trump’s repudiation of the 2015 nuclear deal and the re-imposition of sanctions—officially to negotiate a better nuclear deal that would go beyond 2025 and also address Iran’s ballistic missile program as well as its expanding military activities in the region, possibly with the ultimate goal of fostering internal divisions and tensions and provoking a regime change—is hazardous and dangerous. The country is deeply marked by a sentiment of injustice following the hyper-violent Iran-Iraq war. It is a proud nation that can be expected to unite when facing other injustices. The economy is much less dependent on oil than usually assumed, whereas financial sanctions, trade restrictions and lack of investments are more problematic. The regime has proven remarkably resilient since 1979 and against this backdrop, the hardliners may well become more aggressive, whereas the reformers may be increasingly weakened and marginalized, with average Iranians left hostage, and helpless, in a wider geopolitical conflict and internal power struggles. Iran could well leave the nuclear agreement altogether, opening the way for further confrontations, if not wars, that will leave no winners.

Iraq has faced the triple storm of falling prices, the fight against ISIS and severe tensions with the Kurdish Regional Government (KRG), which culminated with the referendum for independence and the re-taking of key oil fields controlled by the Kurds by the central government’s army. The country is on the path to overcoming these challenges and its stabilization, reconstruction and pacification will be helped by higher oil prices and production. Nonetheless, the country will have to address urgently critical challenges: diversifying its economy, developing its agricultural sector, reforming its institutions, combating corruption, and attracting investment. These challenges will be very hard to address and it will take strong and credible leadership and responsible behavior by foreign powers to succeed. China in many aspects was a key backer of several weakened oil producers: it made inroads or provided investments or credit to Russia and Venezuela notably (to state or private stakeholders). Yet the crisis is expected to have a structural impact on China’s overseas strategy: Angola and Venezuela turned into poisoned debtors so that China’s generous credit lines in return for future oil supplies and infrastructural development may be reconsidered in future. However, China is expected to be the key winner from the new confrontation with Iran at the expense of Western interests and companies, leaving Iran no choice but to go East, towards India and China. The other unfolding geopolitical changes are Russia’s engagement with Saudi Arabia, which is only an oil alliance so far but has the potential to widen, and a major question mark over China’s role in the Middle East, given its significant imports of Saudi, Iraqi and Iranian oil.

Adaptive up & mid-stream strategies and corporate reconfigurations

National oil companies reduced their capital expenditures and drilling operations (with exceptions in Russia, due to the ruble’s depreciation and flexible taxation), and moved to prepayments or managed to issue bonds. Traders such as Vitol, Trafigura and Glencore have certainly strengthened their positions in becoming creditors to several national oil companies. So did China and Russia, yet with unsatisfactory results. Nonetheless, major investments have been sanctioned, mainly in partnership with foreign companies: for example, in Azerbaijan (ACG-BP) or Kazakhstan (Tengiz- Chevron). Others were pushed back and oil exploration efforts delayed, as in Russia’s Arctic, which is marked by high costs and technological constraints following sanctions. In Algeria, a February 2016 energy policy meeting laid out priorities for structural reforms, but was not implemented. Investment friendly amendments to the hydrocarbon law are being worked out, with no certainty over timing and content. Privatization and asset divestment have taken place or are being planned in several producer nations, directly in the oil sector or in the overall economy. In Russia (19.5 percent of Rosneft), in Saudi Arabia (5 percent of Aramco now pushed back to 2019), in Angola, in Kazakhstan (KazMunaiGas). Iraq is planning to establish a state-owned oil company. Algeria’s upstream sector requires large foreign investment and technology, yet no change is expected until the 2019 presidential election.

A worrying alarm bell for a fall in prices

The storm of lower oil prices left these oil producers weakened and their ability to navigate another similar storm will be largely diminished. If prices fall again, they will have lost their fiscal reserves and buffers to resist. Their ability to develop sufficient financial reserves again is uncertain. Their longer term development is at risk: Russia, Azerbaijan, Kazakhstan face a weak banking sector and have tapped into their strategic pension and infrastructure funds. Budgets were curtailed everywhere. Poverty has increased in Russia, Venezuela and Kazakhstan. In Algeria and in Russia, the middle class has been hit. Combined with high unemployment, especially in rural areas, and a very young and growing population, this could lead to tensions in Algeria unless structural reforms address these issues. All these regimes have fossil fuel dominated energy and power generation mixes, which limit their oil and gas exports, represent a subsidy burden and hamper their economic diversification. The ability of these regimes to diversify their economies and energy mix and invest in alternative, low carbon electricity supplies appears weakened. On the one hand, they have a chance to benefit from the falling deployment costs of solar and wind power, and could reap the large benefits of energy efficiency investments. Energy subsidies have indeed been reduced in Iran and Saudi Arabia. Angola and Nigeria have introduced several important reforms, and Kazakhstan has been pursuing the attempt to increase the share of private investments in its economy. On the other hand, the oil rent system itself is unlikely to be changed because many of these countries are involved in wars and larger geopolitical tensions (Russia, Iran and Saudi Arabia), face sanctions or the threat of sanctions (Russia, Iran and Venezuela) and are exposed to social instability, institutional weaknesses and insecurity (Nigeria, Angola, Venezuela and Iraq). Their energy sectors are dominated by state-owned companies (with the exception of Iraq), which can deliver large projects if they have access to finance. But they cannot change a country’s energy governance and system marked by inefficiencies and corporate governance challenges (Russia, Iran, Venezuela, Nigeria, Angola and Algeria). With renewed sanctions, Iran’s economy of resistance may well be perpetrated further. Priorities may be elsewhere: Saudi Arabia has just raised its military spending by 10 percent. Yet among all these countries, Saudi Arabia’s Vision 2030 plan unveiled in April 2016 clearly stands out as one of the boldest and most realistic programs to diversify an economy. But it can only succeed if the society becomes more inclusive and if the country reduces its geopolitical exposure. Algeria also has a large, untapped potential to diversify its energy and electricity mix and reform its economy, but this will depend on political will, a change in government and in the governance of state-owned enterprises, as well as the ability to attract more foreign and private investments.

 

Text extracted from the Report: Navigating the storm: “OPEC +” producers facing lower oil prices (Ifri Center for Energy, 2018)

 

 


Marc-Antoine Eyl-Mazzega joined Ifri’s Centre for Energy as a Director in September 2017. Prior to this, he spent six years at the International Energy Agency (IEA), notably as Russia & Sub-Saharan Africa Programme Manager where he conducted oil and gas market analyses and was responsible for institutional relations with these countries and regions.