Oil, Opec and the Revenge of Rosneft's Sechin

Wednesday, November 24, 2014: Ali Al Naimi, the former Saudi oil minister, signals that Saudi Arabia was changing its oil production strategy from oligopolist – as the main swing producer that keeps oil prices high – to capitalist, and would go for market share. This would lead to lower crude oil prices. The Venezuelan foreign minister, Rafael Ramirez, replied that the prices at the time of about US$62 per barrel would not allow for the necessary investment in oil production capability and would lead to a massive price surge when oil demand increased in the future and that there wasn’t enough spare capacity to meet that demand.

This has been an oft quoted warning by many others over the years.

May, 2015: the Rosneft chief executive and close Putin adviser Igor Sechin states that Opec is dead. Rosneft is Russia’s main state-owned oil company. Opec being “dead” means that Mr Sechin does not believe that oil prices can be managed. Keep this in mind – the most powerful man in Russian oil said a little over a year ago that oil prices cannot be managed.

November 30, 2016: Saudi Arabia reverses its position and agrees with Opec members for a collective cut in oil production of 1.2 million barrels per day (bpd) starting in January. Commentators point to Saudi’s fast-deteriorating budget deficit as the main reason for its change in position. Saudi Arabia’s ability to raise the largest emerging market sovereign bond issue recently is not discussed in relation to the production cut announcement.

Wednesday, 9 December 2016: Mr Sechin announces that Qatar and Glencore will buy 19.5 per cent of Rosneft from the Russian government. If Mr Sechin has announced that effectively oil prices will remain low as recently as last year, why then would anyone buy into Rosneft, especially as it is a high-cost producer compared to Qatar’s neighbours? Iran is practically begging for investment in its oil sector. Saudi Arabia has announced the IPO of Aramco. Plus Iran and Saudi Arabia aren’t under the politically risky cloud of sanctions.

Sunday, December 11, 2016: Non-Opec oil-exporting countries, led by Russia, agree to a production cut of 558,000 bpd in addition to Opec’s already announced cuts. Russia has announced that it would cut production by 300,000 bpd. But doesn’t that go completely against Mr Sechin’s analysis? What about the fact that the cut was announced just after Russia sold a multibillion dollar stake in Rosneft to Qatar and Glencore? Since Russia would have known it would cut, why sell 19.5 per cent of Rosneft just before an announcement that would increase the price tremendously?

Also, if they didn’t disclose their decision to cut output to the buyers ahead of time, then the Russian government traded on insider information. If they disclosed the information, they seem not to have done it publicly, as it appears to have only come out subsequent to the news of the sale, and since Rosneft is a publicly traded company, that means everyone else who traded during that period might have been taken advantage of by Rosneft, Qatar, Russia and Glencore.

The price of crude oil has increased. However, it is a bad bet to believe that there will not be a subsequent crash. The reasons are two-fold.

First, the actions of Russia and Rosneft are simply not consistent with a belief that oil prices will increase. The only way that Russia and Rosneft can know this is if Russia does not plan to honour its commitments to cut production. It is worrisome when such a large trade happened around such a large announcement. Somebody got the short end of the stick and that normally means others will end up with the short end of the stick as well.

The second issue is this idea that low oil prices are leading to a lack of investment in production capacity, which would lead to huge price spikes in the future. There are two major economic errors here.

The first error is in understanding the demand curve. Demand for oil might move fast, but it is still a smooth curve. Oil spikes in the recent past are due not to technical production capacity but to geopolitical issues that degrade production or increase perceived risk, such as the invasion of Kuwait, the invasion of Iraq, the sanctions against Iran and the civil war in Libya.

I promise you that if it is possible for an economy to wake up one day and massively increase energy intensive GDP overnight then someone would invest in preparing oil production capacity. But energy intensive GDP means factories, and building factories takes time.

The second major error is in understanding the supply curve. The supply curve is far from smooth. Whatever you think the shale oil break-even point is, when it hits it comes online very quickly and in size. If demand goes up, conventional oil spare capacity is meaningless. The producers of such new capacity are wasting their money. They will never actually use it, at least not in a commercially viable way.

The idea that the world needs spare conventional oil is a mirage. It is far better to invest in the economy. Oil is not part of the economy, it is simply something stored underground that gets monetised. If we don’t invest enough in our own economy, we are going to pay the price in terms of a permanent drop in standard of living. It is not an investment to create capacity to pump a depleting asset. We need to more rationally look at how to invest what we have, including savings from cancelling the non-commercial idea of creating spare oil production capacity, into creating a real, sustainable economy.

Oil crashed. Economies crashed. Therefore we do not have a real economy. We were therefore living a quality of life that was not sustainable.

Time to accept that, roll up our sleeves and build it right. If anybody wants to sell oil without producing, then it is easy. Saudi Arabia’s Deputy Crown Prince Mohammed bin Salman showed how.

The introduction to this article is: Oil: A Tale of Obfuscation. You may also enjoy: Saudi Oil Price, the Global Economy and Correcting Media EconomistsSaudi Oil Price Redux, Saudi Oil: Through the Looking Glass & Other Adventures in Investing, Second Order Questions and Sterilising the Oil Price Effect and Shale Oil Producers: Swing Producers or Price Takers?

This article was originally published in The National.