The Russian-Saudi alliance over oil is tactical. The Kremlin prefers lower prices to keep US shale at bay
The great oil slump is to last longer than the First World War, matched by grinding financial attrition and political fatigue.
The Opec cartel and the Russia-led Nopec group have today extended their output cut of 1.8m barrels a day (b/d) until the end of 2018, a blow to petro-power fortunes that few thought possible when crude prices first cratered in the summer of 2014.
Cuts of this magnitude are what it takes in the age of US shale to clear the glut and to stop prices slithering back to painful levels, below the fiscal break-even cost of almost every Opec producer. Frackers in Texas respond so quickly to price signals that they have stretched the traditional recovery cycle of the oil industry from two years to four years, and perhaps even longer.
The oil producers must keep one eye on a second and entirely different threat in the complex geometry of energy markets. If prices rise too fast, they will accelerate the shift to electric cars, lorries, and short-haul aircraft. Somewhere in this murky calculus is an optimal figure – probably under $60 – that allows Big Oil to extract maximum revenue as it goes into slow systemic decline.
What is clear is that even the new alliance of Opec and Nopec is not quite enough to regain market control. What began as temporary restraint – "over by Christmas", so to speak – is taking on the character of permanent trench warfare. The Saudis are digging in deeper.
Saudi energy minister Khalid al-Falih said the market is “not yet where it needs to be” on inventories. Demand will soften for the next four months. He called for discipline to whittle down stocks by another 150m barrels towards the five-year average. A supply surge from Kazakhstan and Brazil early next year means that the rebalancing may be delayed until deep into 2018.
Russia diluted the message with talk of an exit strategy or "soft-landing". The deal reached in Vienna includes a review clause in June with linkage to inventory levels, political risk, and shale. It smacks of "tapering" although Brent crude held firm at $63 – up 35pc since the mini-rally began June – on solid coalition rhetoric from Russian energy minister Alexander Novak. “We must continue to act jointly. We’re still far away from the final goal,” he said.
Markets doubt whether Russia will comply fully with the cuts. The country’s interests are not aligned with Opec: it is a tactical alliance. Chris Weafer from Macro-Advisory says the Kremlin has a higher tolerance for depressed prices since the floating rouble cushions the budget. Russia aims to balance the books at oil prices of $44 by 2021 under its fiscal plan, compared to $113 four years ago.
Russia has ultra-low production costs and is loathe to cede market share. Mr Weafer said it prefers a price range in the $50s, fearing that the mid-$60s will galvanize US shale and Canadian tar sands, leading to another glut and a collapse in prices later.
The Opec-Nopec deal is a tightrope act. If the market recovers too quickly, US oil drillers will race to lock in forward delivery contracts. Wood Mackenzie said explorers hedged 900,000 barrels in the third quarter, matching near record long positions built up by fickle investors chasing momentum. The average contract for West Texas crude was around $52.
A rise in 2018 and 2019 futures prices would lead to an avalanche of hedges, triggering a surge in the US rig count. There are signs that this is already happening. “In the past three weeks US drillers added back half of 39 oil rigs that were pulled during the previous three months. US oil production has reached a record 9.66m b/d,” said Ole Hansen from Saxo Bank.
Analysts are starkly divided over the scale of shale threat. Rystad Energy said US output will jump to 9.9m b/d as soon as December, up by 600,000 b/d in four months and confronting Opec with a Sisyphean task.
Robert Morris from Citigroup carried out a detailed micro-study of drilling costs in the Permian basin in West Texas, concluding that the prolific field will triple again and vault past Saudi Arabia's giant Ghawar field (5.7m b/d) to reach 6.8m b/d within four years.
The International Energy Agency forecast in its world outlook that US "tight oil" will account for 80pc of all new global supply by 2025, rising from 5m to 13m b/d. Total US production will hit 17m b/d. “The US will become the undisputed global oil and gas leader for decades to come. The growth is unprecedented, exceeding all historical records,” it said.
Sceptics are unmoved. Paul Horsnell from Standard Chartered said a “wave of realism” is at last hitting shale as cash-flow tightens and well productivity slips. “We think the optimism is overdone,” he said.
Morgan Stanley says shale is facing capacity constraints. Costs are rising and the low-hanging fruit has been picked. Creditors are forcing gung-ho drillers to show discipline. While the wellhead break-even cost may be just $42, there must be a further 30pc premium in the price to unleash investment.
The great unknown is what happens in China, now the driver of global oil demand. Most analysts thinks that the Chinese economy will cruise ahead at a growth rate above 6pc for years to come. That may prove to be a false assumption now that president Xi Jinping has established his grip on power and locked in his place in Maoist pantheon. A proxy gauge by Capital Economics suggest that growth has already slowed to 5.6pc, the weakest for a year.
If Mr Xi concludes that he must bite the bullet and deflate the Chinese credit boom before it is too late, it will take even longer to bring oil markets back into balance. A weary Opec and Nopec may find themselves facing the same set of decisions a year from now. The hard times may yet last as long as the Napoleonic wars.