The Fuse

Why Freeze? Why Now?

March 22, 2016

Guest Post by Matthew M. Reed | @matthewmreed

Matthew Reed is Vice President of Foreign Reports, Inc. and a non-resident fellow at New America and the Payne Institute at the Colorado School of Mines.

Since February 16 oil prices have surged about 40 percent after Saudi Arabia, Russia, Qatar and Venezuela met to discuss a possible production freeze. The talks were the first real sign that low prices had forced top producers to start working together. Since that fateful OPEC meeting in November 2014, when Saudi Arabia declined to cut production and bail out its competitors, prices had plummeted and stayed low.

Days before the February 16 meeting in Doha, oil fell to $26 a barrel. Today, one month after the first meeting in Doha and a month before a follow-up meeting which may include another dozen producers in addition to the original four, prices are above $40 and holding steady for now.

Today’s freeze isn’t a hard sell. It’s a virtually pain-free commitment for those producers facing production declines. A more inclusive agreement like the one to be discussed on April 17 in Doha signals that cooperation is possible. It buys time for serious talks much like a ceasefire does. At this point it’s clear to everyone that there are no winners—only losers who have lost more or less. That’s not to suggest there was a win-win solution in the first place; certainly not in late 2014.

The freeze represents progress even if it isn’t decisive immediately or by itself. More than anything a freeze deal is a bet on demand.

In this way, the freeze represents progress even if it isn’t decisive immediately or by itself. More than anything a freeze deal is a bet on demand. Freezing supply and counting on limited production increases elsewhere (e.g. Iran) should allow for demand to catch up more quickly than it would otherwise. Ultimately, today’s historically high oil stockpiles—bloated by cheap oil—will have to be addressed as well. Crude oil demand in the U.S., China and India is robust enough to give producers hope. Although it’s hard to predict just how soon today’s glut will correct itself, popular predictions hold that the oil market will come into balance this year or next. That may or may not be soon enough for producer countries, inside and outside OPEC, which are hurting from low prices.

A coordinated production cut would lift prices like nothing else, but that’s not an option quite yet. Last month, Saudi Oil Minister Ali Naimi made that clear. The February 16 “Freeze is the beginning of a process, and that means if we can get all the major producers to agree not to add additional balance, then this high inventory we have now will probably decline in due time. It’s going to take time,” Naimi said. “It is not like cutting production. That is not going to happen because not many countries are going to deliver even if they say they will cut production—they will not deliver. So there is no sense in wasting our time seeking production cuts,” he added. Naimi spoke about a lack of trust among producers. Presumably, that trust deficit could be remedied if producers commit to a freeze and stick with it this year.

The freeze is gaining traction for other reasons, not just because producers are growing impatient or because it’s a less risky commitment than significant cuts. The first development that’s encouraged producers is Iran’s modest comeback. Leading up to the lifting of sanctions in January, Iranian officials promised they would immediately raise production by 500,000 b/d. Yet in OPEC’s latest report Iran says it only managed to raise production by 15,000 b/d. Iran is returning to the market gradually because it’s fixated on securing longer-term deals, which take time to negotiate, and/or because it’s having trouble increasing production. What’s overlooked is that Tehran can afford to be patient now that it has access to tens of billions of dollars in old oil revenues that were off-limits under sanctions.

Iran’s underperformance represents the best-case scenario for markets and Iran’s rivals, even if it’s early yet. A gradual return gives others confidence that they aren’t merely paving the way for Iran to surge ahead. Before, no deal seemed possible without Iran. Now producers say they can proceed without it because so many others are on board and Iran’s return has been slow-going.

The other factor is falling U.S. production, which is easy to follow because U.S. data is relatively timely and reliable. Going back to 2014, producers like Saudi Arabia have insisted that the glut is too great for a few OPEC members to fix. They’ve instead called for OPEC and non-OPEC cuts so that the pain is shared. While many hoped Russia might cut output together with OPEC, those sought after non-OPEC cuts are now coming from North America.

For now, a freeze is good enough because it’s easy.

Only in recent months have trends in U.S. oil production really come into focus. It’s obvious now that the shale patch is hurting from declining prices and a slashed investments. The damage done might be worse if not for technical advances but the numbers are grim. The EIA now estimates that U.S. production will average 8.7 million b/d this year—down one million b/d from its April 2015 peak. Other countries are hurting too even if there’s proof U.S. production is falling more rapidly.

With some measure of trust restored, a gradual (i.e. less disruptive) Iranian comeback and shrinking U.S. production, the stage is set for a freeze to pay off later or for bolder action if producers lose patience. Even if the freeze fails to balance the market, it may still narrow the supply-demand gap to a point at which OPEC and non-OPEC cuts become a viable option again.

Those talks will have to wait. For now, a freeze is good enough because it’s easy. It buys time for encouraging trends to play out. It builds trust to be tapped later. And most importantly: It’s pushing prices up even if shifts in the fundamentals lag behind. “Look at what it [the move towards the oil freeze] did to change the psyche of the market” an unnamed OPEC delegate told the Financial Times today.