Getting Russia and Saudi Arabia to agree on an oil freeze is only half the battle

Traders had been anticipating a production cut, not a mere freeze

Russian oil refineries have stepped up production to retain market share (Reuters)

This week’s Doha agreement between Saudi Arabia and Russia to freeze oil production at last month’s levels of output in order to stabilise the global oil price initially left most financial traders unimpressed.

The price of a barrel of the black stuff fell, rather than perked up, in the wake of the announcement: the opposite of what was hoped for. Traders had been anticipating a production cut, not a mere freeze.

But, while the traders carried on selling, some strategists hailed a major geopolitical shift. Until recently, the Saudis had seemed confident that the oil price would soon stabilise of its own accord. Plus, it suited the Kingdom to see rival high-cost US shale oil producers (the major new entrants to the market in recent years) under the cosh. Rather than cutting production, Saudi increased it, with an eye on snaffling up a larger market share when the shake-out was over.

But now, with some forecasting that oil prices will slide all the way down to $10 a barrel, the powers in Saudi are beginning to fret. The Kingdom’s budget deficit has ballooned as oil profits have collapsed and Saudi is being forced to flog off its trove of foreign exchange reserves at a disconcertingly rapid rate in order to protect its 30-year-old currency peg with the dollar.

Russia, another country whose economy is reliant on petroleum, has faced similar agonies thanks to the 70 per cent global oil price crash since 2014. Like the Saudis the Russians have stepped up production, to retain market share. Unlike the Saudis, Moscow has chosen to abandon its currency peg with the dollar. Yet the domestic Russian economy is still in severe crisis.

Geopolitics seemed to make a deal problematic. Russia is at odds with Saudi over the Syrian civil war, with Vladimir Putin propping up President Bashar Assad and the Saudis propping up the anti-Assad rebels. Yet both states have a common economic interest in stabilising the global oil price. And now they have switched strategies. The de facto leader of Opec (Saudi) and the largest non-Opec oil producer (Russia) have managed to put their differences aside.

The key question now is whether the Saudis (along with Venezuela and Qatar, who were also party to the Doha agreement) will be able to persuade the rest of the Opec cartel to agree to a production freeze? Iraq might be amenable. The UAE’s oil minister said on 17 February that the country is “open” to co-operation.

The major obstacle is Iran. Tehran re-iterated that it will defend its “right” to raise oil exports to the levels that prevailed before Western sanctions were imposed in 2011. Tehran’s envoy to Opec blamed the rest of the cartel for increasing production in recent years, at Iran’s expense, and effectively warned that it will not be screwed over twice.

There has been some talk of a special dispensation for Tehran from the proposed freeze. Yet to even consider this possibility emphasises why co-operation among Opec members has not seriously been on the table until now.

Back in the early 1980s, Saudi Arabia cut its production in order to support prices during a previous supply glut. But the Kingdom found that other Opec members, including Iran and Iraq, failed to honour their own commitments to do the same. They effectively got a free ride and built market share thanks to the Saudi “sacrifice”.

If Tehran gets a special break this time around, why would others abide by the rules when it came down to it? After all, everyone needs the money. That prisoner’s dilemma is probably the reason why Saudi only proposed a production freeze, rather than an outright cut. It thus limited its own potential downside risk, but also weakened the power of the proposal to support prices. The trouble with cartels is that unless everyone agrees, no one agrees.

Oil was up sharply on 17 February, despite these issues. But perhaps traders called this one right first time – and oil really is heading for $10 a barrel.