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OPEC Has Taken Back the Driver’s Seat in the Oil Market

Saudis and Iranians finally find a measure of agreement

As more details emerge regarding the meeting of the Organization of Petroleum Exporting Countries (OPEC) at Algiers last week, it becomes apparent that the rumours of the cartel’s impending death were greatly exaggerated. The OPEC has shocked the world with a production cut deal that was simply considered impossible against the backdrop of the bitter rivalry between the kingpin of the cartel, Saudi Arabia, and Iran. In the event, amidst much horse trading, a deal became possible with Saudi Arabia agreeing that Iran, which is recovering from years of western sanctions, can be exempted from any cut in production.

How to explain this development that has stunned the West? Let me retrace to a column I wrote a month ago for Asia Times entitled Pay heed to the butterfly effect of Putin-Salman oil deal in Hangzhou. What we are seeing are the first signs of a tectonic shift in oil politics with Russia positioning itself to replace the United States “from its 70-year old pivotal status as Saudi Arabia’s number one partner in energy”. Interestingly, Russia’s Energy Minister Alexander Novak was waiting in the wings through the OPEC meet in Algiers, although his country is not even a member of the cartel.

How far Novak brought about proximity between his Saudi and Iranian counterparts is hard to tell, but for sure, Moscow played a behind-the-scenes proactive role to encourage a modus vivendi between Riyadh and Tehran on this front. For both Russia and Saudi Arabia, the low oil price is hurting their economies, as it means reduced income from oil exports, which is their main source of income too. Iran is better off because, paradoxically, the years of western sanctions on its oil exports compelled Tehran to diversify its economy away from critical dependence on oil. Oil exports today account for less than one-third of Iran’s income.

However, Iran insisted on its sovereign prerogative to regain its share of the oil market as it existed in the era before western sanctions were imposed, and Russia and Saudi Arabia have conceded the legitimacy of that demand. On the other hand, the deal at Algiers – cutting oil production to 32.5 million barrels per day from 33.47 in August – has been possible only because Saudi Arabia agreed to take on the bulk of the ensuing obligation to cut back on production level. Make no mistake, this is a huge concession by Saudi Arabia. On the other hand, Saudi calculation would be that if the oil price could be sustained at an appreciable level above $50 per barrel, its income would improve, and at any rate, the imperative need for Saudi economy is to put in place a ‘floor’ to support consistently agreeable (and steady) level of oil prices.

With low oil prices, Saudi Arabia has run into a budget deficit of around 15% of its GDP, which has compelled it to tighten belt by rolling back on wages. The Saudis have already burnt through $150 billion of their foreign exchange reserves to subsidize the budget. Nearly a quarter of the reserves are depleted already. Interestingly, Saudi oil minister Khalid al-Falih headed for Algiers from a cabinet meeting, which decided on a 20 percent cutback in the wages in pursuit of austerity. (Reuters)

Indeed, in order to get the Algiers deal going – it is slated to come into effect in November – Saudi Arabia will have to oversee major production cuts. Reducing 1 million barrels of oil from the market on daily basis is no small matter. However, if the deal holds good, according to the estimation by analysts at Bank of America-Merrill Lynch, oil prices could be expected to reach $60 by next year, and would be cruising toward a mid-2017 target of $70.

Without doubt, we are done with sub-$40, and there are profound consequences here for both oil producers and the consuming countries (such as India.) The deal worked out at the OPEC meet at Algiers underscores a new reality in world energy markets. Of course, OPEC does not account for the whole market by a long way. And the very large oil producers outside OPEC – United States, Russia, China and Canada – can take advantage of the cartel’s ceiling on production. But that is in theory only. Russia, for a start, is swimming with the OPEC tide and can even be called its Pied Piper. Besides, OPEC holds about 40% of world oil market and it has a successful history of responding to low oil prices by cutting production.

To be sure, the western capitals, especially Washington, will feel disturbed at the OPEC’s Algiers decision. That is not only because they disapprove of the kind of market management that OPEC is aiming at but also because there is a geopolitical angle to it, as I mentioned above. To quote from my article in Asia Times,

  • An understanding between Russia and OPEC holds the potential to completely transform the geopolitical alignments in the Middle East… This shift cannot but impact petrodollar recycling, which has been historically a robust pillar of the western financial system… The Saudi-Russian energy alliance holds implications for western economic recovery, which is critically linked to oil prices. In strategic terms, too, Washington’s attempt to ‘isolate’ Russia is rendered ineffective, since Europe’s heavy dependence on Russia for energy supplies will continue for the foreseeable future.

At the end of the day, the astounding thing in all this is the pragmatism that Saudi Arabia and Iran have shown as capable of sharing the centre stage on a common platform despite their bitter rivalry in several theatres such as Syria, Iraq, Lebanon, Yemen, Bahrain, etc. FT has a riveting piece on how Saudi Arabia and Iran, “sworn enemies on opposite sides of proxy wars tearing through the Middle East” could still reach the pact at the Algiers meet – Opec deal: How Riyadh and Tehran poured oil in troubled waters.

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