Policy of freezing oil output doomed to fail

Oil&Gas Materials 31 March 2016 08:00 (UTC +04:00)
Global oil markets have been undergoing a structural shift since the mid-2014. Brent crude dropped 77 percent, from $115 per barrel on 19 June 2014 to $26 on 20 January 2016.
Policy of freezing oil output doomed to fail

By Sohbet Karbuz for Trend:

Global oil markets have been undergoing a structural shift since the mid-2014. Brent crude dropped 77 percent, from $115 per barrel on 19 June 2014 to $26 on 20 January 2016. For majority of the oil producing community this drop in 18 months was regarded as a catastrophe. For some, as if the sky was falling.

Then, Brent price recovered to $40 when March was about to close. Analysts continue to provide, or better said, struggle to explain, the reasons that explain why prices dropped 77 percent in 18 months and then surged more than 50 percent over the past 2 months.

Whether real changes in the supply/demand balance have been at work or other factors such as market psychology, monetary policy, casino capitalism accelerated by financial players, etc, were the main culprit will not find a universally accepted answer.

Bearish news (post-sanctions production increases in Iran, lower demand from a weak Chinese and some other Asian economies, high U.S. oil inventories, stubbornly robust production, more resilient shale oil output than first thought) are among the frequently listed reasons for the drop, and Keynes' animal spirit helped by financial players, a weak dollar as well as hopes that key producers will agree on output freeze at an upcoming meeting in Doha are among the top reasons for the recent increase.

Perhaps, artificial pressure (whatever that may be) to keep oil prices down is also lifting if you pay attention to conspiracy theories. However, none focus on the turbulence we have been witnessing in oil markets since the last 3 months markets due to high volatility.

World oil statistics, in scope and accuracy, are still far from perfect. They are of poor quality, imprecise, mostly contradictory, and subject to sometimes radical but mostly not noticed revisions. Therefore, they can easily lead to misguided conclusions regarding the state of market fundamentals. Without proper attention directed at statistic caveats, the ensuing interpretation of oil market data opens the door to unnecessary volatility, and can distort perception of market fundamentals. The recent roller coaster in oil prices is just a blunt example.

Volatility in spreads among three crude oil benchmarks often has implications on the flow of oil trade. Or perhaps the reverse is true from time to time. Whatever the direction of the causality, traders may switch for instance, from crude oil that's priced off Brent blend to Middle East crude grades that are priced off Dubai.

We can list additional developments that provided oxygen to the already burning market. The lifting of the US crude oil export ban has opened the arbitrage for European sales. Lifting of the sanctions has enabled Iran to boost its oil exports. And OPEC has abandoned its output target.

OPEC's current Saudi-led supply strategy is working or not, is debatable. Prioritizing market share and production over price may be an inappropriate policy at a wrong time with painful consequences. Despite oil production freeze, Saudis perhaps will continue to produce more, particularly when one takes into account of resumption of production at Khafji field jointly operated by Saudi Arabia and Kuwait.

Output freezing policy is doomed to fail simply because what market needs is a reduction in production, not sustaining the current level and hoping that those producers with higher production costs would be forced to cut at one point.

Libya has many other priorities to focus on right now than a possible oil production freeze. Despite the desire to return to pre-civil war production levels, currently a production increase there is unlikely as internal dispute between two governments continue.

Except for Iran, countries that may agree on output freeze are already producing at near capacity, and hence overall impact on production freeze on global supply-demand balance will be little. This is why Iran makes a difference, perhaps not immediately, but soon.

Iran is unlikely to agree on output freeze until its production level reaches pre-sanctions period. At least, this was the motto announced so far. Iran's exports are already adding to the supply glut and more importantly Iran made it clear so far that it wants to regain market share lost in Europe and Asia while under Western sanctions. In this sense, any inclination by Iran towards production freeze could imply a loss in credibility.

Meetings between major oil producers should be more on finding out how to establish a mechanism so that in the mid to longer term prices could cycle in a range between a floor and a ceiling, than simply freezing output which may backfire. How this can be done, however, requires some imagination.

Sohbet Karbuz is the Director of Hydrocarbons, France, Mediterranean Energy Observatory (OME).