Russia and Saudi Arabia: A New Oil Bromance?
November 3, 2017
At the end of October 2017, the OPEC/non-OPEC agreement to cut oil production finally achieved its purported objective of raising oil prices to a level of $60 per barrel. The apparent success in steering the oil market toward a rebalance and bolstering prices is built largely on Saudi Arabia’s overcompliance and Russia’s recent compliance to agreed production cuts, while the rest of OPEC exceeds its combined quotas and negligible contributions come from other non-OPEC producers. Although historical precedents indicate that Russia has preferred to free ride on OPEC production cuts, there are several recent developments that suggest that they may be more committed to cooperating with the Saudis this time around.
First, Russia has in fact reduced its output and achieved compliance, and regardless of operational difficulties, objections by Russian oil companies, and longstanding doubts concerning Russia’s commitment to the deal, if President Vladimir Putin and the Kremlin wish for the agreed cuts to be met, it is very likely that they will be. More than 50 percent of production is controlled by the state through its shareholdings in Rosneft and several other companies, and Putin arguably has a greater hold on the Russian oil sector than ever before.
Second, King Salman’s recent visit to Russia was the first ever by a Saudi monarch. With Russia facing a new set of sanctions from the United States on top of the 2014 coordinated sanctions with the European Union, Moscow appears to be exploring economic opportunities with an alternative group of partners, most notably China and India, but that group appears to be expanding to the Middle East and may include Saudi Arabia given the announcement of more than $3 billion in potential investment deals upon the king’s visit.
While the relationship between the pair may only be one of convenience, likely only lasting as long as both partners believe the benefits outweigh the costs, for the moment at least cooperation appears to be mutually beneficial. The Saudis need a large oil producing partner to effectively influence the market, and the potential for a greater geopolitical and economic role in the Middle East for Russia makes compliance to production cuts an expedient move for Moscow.
With the 173rd Ordinary OPEC Meeting quickly approaching at the end of November, now is an opportune time to reflect upon some of the key uncertainties, motivations, and implications regarding Russia’s involvement in the cuts and its evolving relationship with Saudi Arabia.
OPEC/Non-OPEC Agreement: Further Action Needed
In December 2016, OPEC joined with a group of non-OPEC countries and set out to curtail crude oil output by 1.8 million barrels per day (mmbd) in a bid to rebalance the global oil market. The agreement marked a demonstrable change in tactics on the part of both Saudi Arabia and Russia, the leaders of the two groups. Saudi Arabia departed from its original plan to increase market share to reduce the impact of U.S. shale production. For its part, Russia agreed to join the production cuts even though just two years earlier it openly questioned the relevance of OPEC in the age of quick-cycle shale oil. While the agreement did not explicitly state an intended numerical price target upon its announcement (other than 1.8 mmbd curtailment), secretary general of OPEC Mohammad Barkindo offered some clarity at CSIS in December 2016 by stating that an unofficial quote of $60 oil had been used as an internal incentive within the group to garner supply restriction commitments. Additional clarity was offered in May 2017 upon the extension of the deal for another nine months, when Saudi oil minister Khalid Al-Falih stated that the intended target was to reduce global petroleum stocks to their five-year average.
Russia, in becoming party to the agreement, made the commitment to cut 300 thousand barrels per day (mbd) of its crude oil production on a phased basis. At approximately 11 million barrels per day, this amounts to less than 3 percent of total Russian oil output. According to the International Energy Agency (IEA), Russia achieved full compliance in August and cut production by 318 mbd in September. However, it is worth noting that Russia (along with the majority of other participants to the deal) ramped up production to historical highs in the preceding months to the agreement. Consequently, Russia actually exceeded 2016 crude oil production by 160 mbd for the first six months of 2017. Though monthly production volumes fell below 2016 levels for the first time in September 2017, on an annual basis, Russia has not made a market-share sacrifice while still enjoying the economic benefits of the price increase and the political advantages of being party to the OPEC/non-OPEC agreement.
Current IEA data indicates that the production cuts are successfully reducing global petroleum stocks. However, even if the cuts are realized through the end of their expiration in March of 2018, global stocks would remain elevated above the five-year average. With the 22-member party to the deal still cumulatively producing in excess of its commitment to the cut in September, doubts linger as to whether the agreement can ultimately survive or succeed in fully rebalancing the market. That said, Saudi Arabia and Russia appear to be doubling down on their commitment to see the task through, with King Salman recently visiting Moscow and announcing that the two countries will continue to work toward stabilizing the market.
A Russian Drilling Rebound Makes Continued Compliance Look Difficult
For Russian producers, contribution to the cut is “voluntary” with 12 major companies that control 90 percent of the country’s output agreeing to reduce their levels of production in accordance with their share of Russia’s total output. Russian companies have primarily responded to the cuts by decreasing drilling activity, rather than shutting in wells. Specifically, less intensive drilling in more mature fields with natural decline has been the key tool toward achieving compliance so far. For this reason, recent drilling volume data offer an interesting indication as to how companies will manage flows for the latter half of the year. Recent data indicate a rebound in drilling activity. In fact, Rosneft, which contributes approximately 100 mbd to Russia’s production cut, has stepped up production drilling. In its latest investor update, Russia’s largest producer announced that during the first six months of the year capital expenditure had risen by 32 percent in ruble terms, and in the second quarter of 2017 drilling activity increased by 33 percent year-on-year.
The results of this drilling rebound materialized in September with increases in production from Rosneft, Gazpromneft, and other producers, offset only by maintenance at the Sakhalin I field. This adds a level of uncertainty to Russia meeting its target level further into 2017 and beyond, given the technical difficulties associated with imposing cuts during winter months, along with the fact that Russian production volumes typically increase toward the end of the year. Multiple Russian companies have stated that they cannot reduce their output without the risk of creating irreversible damage to their wells as a result of freezing Siberian temperatures. As winter approaches, the true level of commitment of Russian companies to the agreement will be unveiled. This is especially true when companies like Rosneft are heavily indebted and have already pre-sold large portions of their future production.
Russia’s Past Performance: Not a Promising Track Record
Adding to these uncertainties is Russia’s track record in previous agreements with OPEC. Since 1998, Russia has been involved in three other OPEC deals and, on each occasion, failed to follow through on its commitments or proposals. In March of 1999, following the onset of an oil price collapse that began in late 1998, OPEC along with Mexico, Norway, Oman, and Russia announced a pledge to cut production by 2.1 mmbd. Of the 388 mbd commitment from the four non-OPEC producers, Russia promised a 100 mbd reduction, but this never came to fruition. In fact, Russian output actually rose throughout 1999, and exports surged by over 400 mbd. The next agreement that Russia became party to followed 9/11 and the subsequent global economic downturn that saw oil prices fall by nearly 40 percent. OPEC convened and pledged 1.5 mmbd with another 500 mbd being offered by a cohort of non-OPEC producers, including a 150 mbd reduction from Russia. The Russian government implemented restrictions on flows through the state-owned Transneft pipeline system, but once again production rose with exports bypassing Transneft through other means of transport such as rail, barge, and truck. In fact, noncompliance on Russia’s part only became apparent after the fact because of the poor data quality on crude flows at the time. Finally, in 2008 following the global economic recession when prices fell by a factor of three, OPEC pledged market intervention. Russia, while not explicitly committing to a deal, informed OPEC that it could reduce output by 300 mbd. Igor Sechin (then deputy prime minister and now CEO of Rosneft) spoke of creating a national oil reserve to reduce export barrels. However, the Russian government instead lowered the mineral extraction tax and export tariffs, which incentivized greater levels of exports. As a result, exports surged by nearly 700 mbd. In each of these three cases, Russia delivered far less than it promised OPEC, to put it mildly
Prices Matter, But It’s Not Just About Oil Prices
Beyond the economic rationale, there are also several broader geopolitical elements at play that may explain a strengthening of cooperation between the two countries. On Russia’s part, the Kremlin is attempting to exert its influence in the Middle East beyond existing partnerships with Iran and Qatar that transcend the prevailing divisions in the region. This attempt is evidenced by Russia’s involvement in the civil war in Libya, investment deals made with the Kurdistan autonomous regional government in Iraq, and an improvement in ties with Sunni Arab Gulf states, Israel, and other parties in Palestine.
A particularly important component of Russia’s involvement in the Middle East to consider is the ongoing conflict in Syria, which now appears to be approaching endgame. The Bashar al-Assad government, with the support of Russia, has successfully quashed the armed rebellion backed by the United States and United Kingdom. The outcome of this conflict is illustrative of a potentially new balance of power beginning to emerge in the Middle East. Vladimir Putin’s sustained demonstration of force, while Western involvement has frayed, has likely caused an internal conundrum for the Saudis and several other countries in the region on how to balance the relationship with Russia and the United States. For Moscow’s part, this show of force may also have been backed up on a more subtle level with an extension of a hand, by ending its criticism within the United Nations against Saudi Arabia’s ongoing intervention in the war in Yemen and by taking a neutral position on the ongoing crisis within the Gulf Cooperation Council.
For the reasons outlined above, the warming relationship with Russia is possibly a sign of a more assertive foreign policy for Saudi Arabia under new Crown Prince Mohammed bin Salman, who has met with President Putin four times since 2015. Mohammed bin Salman may be making a play to hedge his bets by establishing a firmer alliance with the Kremlin given the retreat of U.S. influence in the region. Furthermore, establishing a line to Moscow may also act as an insurance policy in case there is a change in tack from future U.S. administrations on the historically strong U.S.-Saudi relationship, which had already begun to fray under President Barack Obama.
While Moscow has long played the role of a price-taker in the global oil market and an opportunist in previous agreements with OPEC, under the current agreement Russia has been cooperative. That said, it did not have to make a market share sacrifice to reach compliance, and so the real test will come in the proceeding months with the higher price level increasing the incentives to cheat, along with the technical difficulties associated with implementing production cuts during the winter. Furthermore, market data suggest that if the OPEC/non-OPEC agreement comes to an end at its expiration of March 2018 with full compliance, it will not have succeeded in reducing global petroleum stocks below their five-year average. In order to succeed, the agreement will have to be a longer-term commitment to market management, and while it is likely that Russia will agree to an extension till the end of 2018, it remains to be seen if Russia truly has the required resolve to see compliance all the way through.
Edward Chow is a senior fellow with the Energy and National Security Program at the Center for Strategic and International Studies (CSIS) in Washington, D.C. Andrew Stanley is a research associate with the CSIS Energy and National Security Program.
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