It was talked about for weeks. Then it happened. (Or at least a variation of it happened.) Saudi Arabia and Russia, along with Qatar and Venezuela, said on February 16 that they would freeze oil production at January levels, provided other big producers agreed to join them. A day later, Iran said it liked the idea of a coordinated effort to boost prices, yet it stopped short of pledging to limit production. These are some of the most significant developments in the oil saga for quite some time. But what does it all mean? No one seems to know.
A week ago, the U.S. benchmark for crude had sunk to around $26 per barrel. The price now is around $31. That’s not a big move. It suggests the Saudi-led Organization of the Petroleum Exporting Countries and Russia have some work to do if their goal is to lift oil’s value. (Russia is the world’s second biggest producer after Saudi Arabia, but isn’t a member of OPEC.) “The agreement between Saudi Arabia and Russia is as water-tight as a colander,” Krishen Rangasamy, an economist at National Bank of Canada, said after the initial announcement.
One of the holes is the absence of a firm promise from Iran, a country with which Saudi Arabia is engaged in a number of proxy wars. Given the tension between the two nations, the warm words from Iran on a joint effort should be seen as a positive. Still, there is no hiding the fact that Iran hasn’t signed on. The country was the world’s No. 2 producer before it was effectively barred from the global market by international sanctions a few years ago. Those sanctions now have been lifted and Iran has every reason to pump as much oil as it can, whatever the price. Crude is the country’s biggest source of revenue and it is in desperate need of cash.
The absence of any attempt by Saudi Arabia and OPEC to reduce the oil glut was one of the great surprises of 2015. Nearly as surprising was the willingness of Russia and private oil companies in North America to carry on at prices that were understood to be well below their break-even points. For a number of reasons, Saudi Arabia’s competitors in international markets had an incentive to engage in Riyadh’s price war. Russia, fighting a recession, simply needed whatever money it could get. Some of the producers in Canada’s oil sands discovered they would suffer bigger loses if they actually shut down their sprawling facilities.
Realities such as these have made it difficult to apply game theory to the global oil market. A year ago, most analysts were thinking about the situation in terms of a “cooperative game,” in which players would strive for a price that maximized their profits. But Saudi Arabia, Russia, the U.S. shale producers, and others were engaged in a “non-cooperative game.” The players were totally self-interested, bent on preserving market share. That explains the unsure reaction to the Saudi-Russia announcement. According to Rangasamy, it will take a firm commitment from Iraq and Iran and the inclusion of the U.S. to make any unofficial production quota legitimate. It would also require severe sanctions on cheaters. “It’s unclear who would be willing to sign such a binding agreement under the current environment of deteriorating public finances and the need to raise funds to finance wars,” said Rangasamy.
None of those elements are in place, so there is little reason to bet oil is headed higher. Goldman Sachs, the New York-based investment bank, is sticking with its call that crude prices could drop to $20 per barrel. Saudi Arabia and Russia would be freezing production at near record levels, indicating there still would be lots of supply. Helma Croft and Christopher Louney, commodity strategists at RBC Capital Markets in New York, called the agreement between Saudi Arabia, Russia, Qatar and Venezuela “symbolic,” as they think all four countries are producing at maximum capacity. Still, Croft and Louney were optimistic. “It is one of the first clear acknowledgments by the oil heavyweights that all is not entirely well in the current price environment,” they wrote this week. “Additionally it signals a potential willingness to be more proactive later in the year.”
U.S. Federal Reserve Chair Janet Yellen is among the global officials who has said she believes there is a price at which major producers and speculators no longer will be able to endure the pain. That moment may have arrived. Unless economic rationality has little to do with what is happening in oil markets. The players have spent more than a year worrying about no one but themselves. It will take more than promises from countries with the reputations of Saudi Arabia and Russia to convince most market participants that anything has changed.
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