7 min read

Cartel Blanche

The last few days have led to some major whiplash among commodity market watchers, armchair geopolitical strategists, politics fiends, and Eurasianists wondering what the hell to make of OPEC+ of late. Energy Ministers led by Saudi Energy Minister Prince Abdulaziz bin Salman announced coordinated real-terms production cuts of just over 1 million barrels per day (bpd) against a 2 million bpd reduction in production quotas from November onwards. The gap is largely explained by the fact that Russian production is already down compared to existing quotas. Saudi Arabia is reportedly shouldering about half of the load with plans to cut output by 526,000 bpd. The OPEC+ meeting produced a general agreement to extend the current coordination framework through to next December with the following production quotas. All adjustments are in thousands of bpd:

The Biden administration immediately jumped on the announcement of the cut as the short-sighted act of a thankless "friend." The press release sought to dodge the truth of the matter – the White House doesn't want higher gas prices screwing the Democratic Party in the midterms. So instead, they went with a line of concern for poorer importers: "At a time when maintaining a global supply of energy is of paramount importance, this decision will have the most negative impact on lower- and middle-income countries that are already reeling from elevated energy prices." Further releases from the Strategic Petroleum Reserve are on the table to offset the effect of the cuts in the short-run.

Critics of the decision see the cuts as a means to help Russia. Moscow was requesting cuts of roughly 1 million bpd in output by September 27, an about face from public opposition to cuts in early September. It doesn't take a genius to guess why: the EU's import ban has morphed into general support for the US Treasury's price cap scheme. No one really knows how it can be enforced, but the very talk of a future scheme intended to provide either a hard dollar price cap on Russian crude or a % discount against Brent crude prices allows importers today to demand similar discounts in a self-perpetuating cycle robbing the Russian budget of revenues and Russian firms of profits to reinvest. Discounts of $20-35 a barrel are manageable when oil is above $100 a barrel. Not so much when it's around $85 and the budget's nominal breakeven price has risen significantly with the financial demands of the war. The Saudi chart on comparative changes in energy prices also makes clear that the current market context isn't a crude oil crisis, but rather a situation where specific refined product balances continue to be an issue largely due to losses of refining capacity in the US and Europe in 2020-2021 and China's reduced refined product exports this year:

One can't help but notice two other developments in Saudi Arabia that may not be prime drivers of the decision to appear to throw Biden under the bus publicly, but still matter: Mohammed bin Salman was named Prime Minister a week ago, giving him diplomatic immunity from any legal investigation into the death of Jamal Khashoggi and Saudi Arabia has reportedly won a bid to host the Asian Winter Games in Neom, a city in the desert that hasn't even been built yet. Sochi Olympics on crack. The Saudis are going to need a ton of USD coming in to deal with the surge in metals and construction materials demand for all of the building projects folded under Vision 2030 and the expansion of the metallurgical sector and renewable energy. There's more to it, but no one should be surprised they want to play defense in the face of a looming global recession and try to prop up prices.

For anyone wondering how much it benefits Russia, the answer is comparatively little. Russia's output cuts only exist on paper, confirming what's already reality because of sanctions. Higher prices mean a stronger ruble, which makes Russia's exporters less profitable. And if they don't lead to a stronger ruble, than that means the Ministry of Finance is sterilizing earnings, though it's unclear how useful that is anyway since they have a harder time buying stuff with US dollars or Euros now. The other competing issue is inflation, since the Bank of Russia now sees more upside inflation risks and a stronger ruble reduces inflation by making imports cheaper (and the economy still depends on imports for a huge range of consumption). This is from the Bank's monthly release:

Bank of Russia inflation survey, median responses – Blue = expected inflation Beige = observed inflation Red = official annualized inflation

My own guess is that the Saudi Energy Ministry and Aramco gamed it out and thought of themselves first and foremost. Iraq, which accounts for about a tenth of the cumulative cut quotas, isn't even pretending to try to cut output since it's got its own fiscal issues to address. There is no oil alliance. Saudi interests drive this train. One could argue it's a crowning humiliation for the Biden administration after winning concessions on a regional air defense architecture aimed at Iran and the appearance that the JCPOA is dead for the foreseeable future. The September OPEC oil report assumes strong demand growth through the end of next year. There's a seasonality component to demand (rises in Q4 each year for instance) but it projects a nearly 6 million bpd increase in demand between Q1 2022 and Q4 2023. The following is all in mbpd:

If we knock around 1 million bpd off of the supply increase projected due to OPEC cuts and assume no additional production comes online elsewhere (already a bad bet), it seems pretty clear they're trying to get ahead of what they expect will be a significantly weaker economic growth environment. But in so doing, they're driving up the short-term price and passthrough effect of oil prices on inflation at a time when the US dollar is historically strong relative to most major currencies.

The question then becomes what the Biden administration can reasonably do and just how much leverage does Saudi Arabia have? Talk of this benefiting Russia is, in my view, completely misplaced. Higher prices accelerate a global downturn driving down commodity prices across the country's export basket at a time when it's already shot itself in the foot over natural gas exports. The Wall Street Journal immediately reporting that the White House was looking to advance talks with the Maduro government in Venezuela to provide sanctions relief for Chevron to effectively save the nation's oil sector with as yet limited information about what the ask looks like. Thus far, the reporting suggests getting Maduro to commit to free elections in 2024 and the administration is seeking input from the opposition. That seems unlikely, but the prisoner swap just 2 days prior secured the return of US nationals who worked as executives at Citgo for two nephews of Venezuelan first lady Cilia lores. Caracas has been openly courting Wall Street for help killing the sanctions regime, and the OPEC cut has provided communications space for Biden's team to pitch any distasteful rapprochement with Maduro as a means of elbowing out a regime in Saudi Arabia that consistently takes Washington for a ride.

What is surprising, then, is that the scale of the shocks to the oil market since COVID began have marked a variety of haphazard responses from buyers that don't augur well for OPEC's future despite its ability to increase its relative market power in a world of falling demand. The assumption back in 2020 from those looking at the effect of peak demand was that given the Gulf has the lowest production costs in the world and huge reserves, it could leverage its market position as higher cost producers begin to struggle and, as we saw from the depth of the cuts OPEC+ managed, smooth out volatility to protect their revenues. In a world of politically-induced supply constraints, that power is diminished. And in a world where demand uncertainty begins to drag down prices and peak demand seems closer than the oil market's perma-bulls would like to believe, buyers are able to retain their power by coordinating their activity in response to OPEC. Strategic reserve releases (and purchases) have already been coordinated to some degree between geopolitical competitors during the worst of the pandemic market crash and rally. One thing is true no matter what the development of OPEC's market power in these confusing conditions looks like: Russia's oil power is, for all intents and purposes, ending.

Energy Ministry Aleksandr Novak threatened output cuts of up to 3 million bpd in the event the price cap scheme is put into place. Why? Well, they'd rather drag everyone down with them than suffer a permanent political discount. But given the very strong correlation between extraction and economic activity writ large in Russia, such a cut would be ruinous in the middle of military mobilization. No one is keeping track of all the bad ideas floating around to manage the sanctions fallout. Instead, you have a system of parallel 'verticals' and fiefdoms of once technocratic hands forced to spit out whatever fits the meta-aim of regime survival. OPEC's cut, I believe, will prove counter-productive to its aims. OPEC+ has always been a political construct, one that has benefited the appearance of Russian power with little to show for it. Russia lacks spare capacity and cannot raise and lower its output to balance the market easily, instead doing so as a matter of necessity for its fiscal system and economic demand. OPEC hates the price cap cause it tells them buyers may assert power they never have before, dictating the actual price of a globally fungible good produced from one country. It may buy some time, but once demand enters its twilight years, the instruments available to influence the market are proving to be more varied than a simple question of drilling more crude or consuming fewer refined products. There is no long-term anymore, it seems, when it comes to oil politics.

Like what you read? Pass it around to your friends! If anyone you know is a student or professor and is interested, hit me up at @ntrickett16 on Twitter or email me at nbtrickett@gmail.com. Always happy to look at any freelance opportunities pertaining to Russia, Eurasia, energy and commodities, or my old love foreign policy.

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