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Oil prices keep rising after Russia joins OPEC’s big deal to cut production

Oil producers in Russia are, uh, feeling the chill.
(Shutterstock)

Some of the world’s biggest oil producers are trying to see if they can hike global crude oil prices by artificially throttling production. So far, they’ve been stunningly successful — with “so far” being the key term here.

On Tuesday, the price of Brent crude oil rose to $56 per barrel, the highest level since mid-2015. The impetus? Russia, Kazakhstan and a few other countries agreed to voluntarily cut their oil output, following a landmark deal in November by the Organization of Petroleum Exporting Countries (OPEC) — which includes Saudi Arabia, Iraq, and Iran — to limit its own production:

(Nasdaq)

If all these promised supply cuts actually materialize — a big “if” — they’ll eliminate much of the glut in the oil market that’s persisted for two years, the International Energy Agency said this week.

Both OPEC and non-OPEC oil producers are hoping they’ll benefit from a coordinated production cut — that they’ll gain more revenue from higher prices than they’ll lose in foregone output. Yet this agreement is not enforceable, and it remains to be seen if any countries cheat and undermine the deal. The other big question is how US fracking companies will respond to the rise in prices — we could very well see a big resumption in US drilling that floods the market with cheap oil again.

Why OPEC and non-OPEC countries are suddenly cutting oil production

A quick recap on how we got here: Ever since mid-2014, the world has been pumping out far more oil than anyone needs, due in part to the surprisingly resilient fracking boom in the United States and in part to slower-than-expected demand in places like China.

For much of that time, OPEC sat by and did nothing as prices fell. The cartel’s most important member, Saudi Arabia, actually thought it would be better to flood the global market with cheap crude in order to drive prices down and put all those high-cost US shale companies out of business. As a result, oil prices plummeted, at one point falling below $40 per barrel.

Two years later, however, Saudi officials are switching course. The country has been hurt badly by the slump in oil revenues and resulting budget hole — the government has had to burn through more than $100 billion worth of foreign exchange reserves and cut social services and public salaries, threatening stability in the kingdom. Meanwhile, it’s partly achieved its goals: US production has fallen from 9.6 million barrels per day in 2015 down to 8.6 million barrels per day this year amid the price crash.

So recently, Saudi Arabia and other OPEC countries decided it was time to rein in the global oil glut. In November, the cartel agreed to a major deal to limit oil production to 32.5 million barrels per day — down from its current levels of 33.7 million barrels of oil per day. (OPEC represents about one-third of the global market.) Saudi Arabia, Iraq, UAE, and Kuwait agreed to make the biggest cuts, which totaled 1.2 million barrels per day in all. Oil prices surged worldwide after the agreement.

But there was a catch: OPEC’s members said that as part of the deal, they wanted other non-OPEC oil producers, especially Russia, to make their own cuts worth 600,000 barrels per day. Over the weekend, the non-OPEC countries agreed to (mostly) do just that, signing on to cuts worth 558,000 barrels per day, with about half coming from Russia and another 200,000 bpd coming from Kazakhstan. Presumably, these countries all made a similar calculus — they have more to gain from cutting than from cheap oil.

Shortly after the non-OPEC deal, Saudi Arabia hinted that additional cuts might be in store down the road. So that’s what’s responsible for the current rally in oil prices.

In the short term, it will mean more revenue for countries that export oil and shore up their budgets — but it will also mean higher prices for drivers in the United States, Europe, and elsewhere. Some US states may see $3/gallon gasoline in 2017, a sight not seen in years.

It’s still unclear if the OPEC deal will hold — and the United States is a wild card

That said, it’s unclear if Saudi Arabia, Russia, and the rest of these countries can actually hold the line and successfully limit global production. In the past, both OPEC and non-OPEC countries have been known to cheat on agreements to limit production. “That’s something we’ve absolutely seen in the past,” Jason Bordoff, founding director of Columbia University’s Center on Global Energy Policy, told me last month.

OPEC’s members (and non-OPEC countries like Russia) face a big coordination problem. Each of these oil producers would benefit from higher global prices, but every individual country would rather that someone else make the actual cuts. Without any real enforcement mechanism, the incentives to cheat are high.

And even if there’s no cheating, these oil exporters face another, more serious quandary. Over the past two years, the fall in oil prices has put a damper on project investment in places like the United States and Canada and Brazil, because fracking and oil sands and deepwater projects need relatively high prices to make investing worthwhile.

But if OPEC successfully throttles back on production and hikes prices, that could induce some fracking companies in Texas or North Dakota to start drilling again. At that point, supply would rise and prices would fall. OPEC would be right back where it started — except it would have lost market share.

The tricky part is that no one knows exactly how this dynamic would play out. Bordoff notes that forecasts vary wildly on how much US oil production could grow again if prices rise to, say, $60 per barrel — some analysts suggest an extra 300,000 barrels per day, others 900,000 barrels per day. “It’s a big uncertainty range,” he says.

Part of this is uncertainty about the “break even” point for many projects in the United States — the price at which it’s profitable to drill. During the price crash, many fracking companies managed to slash costs, but it’s often unclear how much of that was due to sustainable efficiency improvements and how much was due to unsustainable moves like squeezing suppliers or focusing only on the most productive wells (which they can’t do forever).

“The uncertainty about US shale is a huge game changer for OPEC,” Bordoff says. “If prices rise to $60 and a large volume of oil can come back quickly, that’s a very significant constraint on the ability of OPEC to manage the oil market that we haven’t seen before.”

The popular view of OPEC is that its members can sway the global oil market with a single utterance. We saw this in 2008, when prices were plummeting amid the financial crisis and OPEC stepped in to halt the slide. But OPEC doesn’t have the same power it used to. Over the past two years, the cartel has been paralyzed by indecision, watching as US shale drillers flood the market and swing global prices. Saudi Arabia and its allies are now trying to reassert their grip.

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