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The media analyses of the OPEC deal have focused mostly on the details. Which countries will cut production and by how much they will cut. As analysts crunch the numbers to work out when storage levels will fall, we are left wondering what all of this means to us in the oil industry. What can we learn about this OPEC deal? Here is my very short take on the situation.
Some argue that the policy of the Kingdom of Saudi Arabia (KSA) not to cut production amid significant drop in oil prices in 2014 had been politically motivated, that is, it was to put pressure on Iran and curb shale production in the US. Whatever the underlying reasons were, the policy has failed dramatically and the KSA has hurt the most. According to JP Morgan’s analyses, at current production and with oil prices remaining at $50 per barrel, the KSA will have a budget deficit of over $60 billion in 2017. That is equivalent to 10 percent of the KSA’s GDP.
The success of member countries in OPEC is not just related to keeping the oil prices up; attracting investments to oil projects in their countries is far more important over the long term. Considering the level of investment in the Kingdom in the last two decades, the KSA OPEC policy has not been unsuccessful in increasing its export capacity. However, in 2014 KSA underestimated both the resilience of the US shale industry and their own threshold for pain as KSA’s deficit steeply rose throughout 2015.
It is important to recognize that the bargaining power within OPEC and externally, with non-OPEC competition, evolves around production capacity. In order for OPEC to exert any meaningful influence in today’s oil market, the KSA has to be able to cut production and act as a swing producer when needed. In other words, until Saudi Arabia builds a more resilient economy and is able to take on a significant production cut of more than 1 million barrels per day over a period of a year, any OPEC intervention in the market place will be short-lived.
That’s right, I believe that the current OPEC deal will most likely fail in its intended objective of balancing supply and demand levels globally into May 2017. In fact, you could argue that it has already failed because the oil prices did not rise to OPEC’s target $60 per barrel. First, the cuts are not deep enough to drain the oversupply and, second, as Nick Butler puts it eloquently in his article in the FT, “the incentive to cheat is too high”.
That means that oil companies looking for growth opportunities need to prepare for a world where OPEC will effectively be unable to provide a floor for oil prices. Oil companies and service providers need to invest heavily in innovation and think twice before making investments in expensive basins, where cash cost of producing oil is high. Technological innovation to reduce costs across exploration, development and production will become the key influencer in the industry over the next decade. Oil companies have to cut costs through innovation whilst increasing revenues by investing into lower-cost basins to produce any meaningful value for shareholders.
The other key take-away from this OPEC deal was Iran’s success in achieving its objective. In 2016, Iran has added more production than any other OPEC country and was given a let-off from the cuts agreed by OPEC. Local media and commentators in Iran have praised the oil minister Zanganeh’s successful diplomacy. However, to increase production beyond this level (i.e. approximately 4 million barrels per day), Iran will need to attract foreign investment from oil majors.
Iran’s oil diplomacy focused on two key objectives. First, Iran intended to demonstrate that the country was not against an OPEC deal to cut production but that it had a good reason not to be part of it. Since, Iran has successfully achieved this objective and its cooperation in reaching the deal is undeniable.
Second, Iran is utilizing its upstream projects on offer to lure in major oil companies from Asia and increase its market share in the region. Iran has put considerable diplomatic efforts into strengthening its bi-lateral trade relationship with countries in Asia and South Asia. This is the right thing to do for Iran. Not only do countries in Asia constitute a significant market for Iranian oil, they are also more willing and able to invest into Iranian upstream projects.
The recent agreement between Total, CNPC, Petropars (Iranian partner) and National Iranian Oil Company on South Pars Phase 11 provide a suitable working model for IOCs eyeing Iranian fields. This, perhaps, is a good structure for the development of some of the other large fields on offer in the country. Chinese companies can utilize a low-cost supply chain whilst providing low-cost financing solutions.
In the next few weeks, Iran will announce the long list of qualified IOCs to bid for offered fields and may decide to host tenders on a number of priority fields shortly after. The recent OPEC deal has no doubt emboldened Iran to press on.
Afraz Advisers is a Middle-East focused advisory firm providing technical and commercial insights for large oil companies, corporates and investors. Since 2013, Afraz has undertaken a comprehensive review of the oil and gas development projects in Iran and a wide variety of associated investment opportunities. The company’s flagship product “Iran Toolkit” is the industry standard for oil companies evaluating fields on offer.
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