OPEC’s new oil production targets call for a relatively modest cut of 4.5 percent but the agreement is expected to deliver dividends amounting to billions of dollars in additional government revenue in 2017. Driven by an acute financial imperative to provide relief for beleaguered government coffers via higher oil revenue, OPEC overcame an array of divisive issues and agreed to lower crude oil production by 1.2 million barrels per day (mb/d), to a target of 32.5 mb/d, for the first six months of 2017 in a bid to reduce the global supply overhang that has weighed on oil prices for the past two years. Russia has also committed to reducing supplies by 300,000 b/d (kb/d), bringing total planned cuts to 1.5 mb/d, effective January 1, 2017. Other non-OPEC producers are still discussing combined cuts of 300 kb/d, which, if they materialize, would push total global oil production lower by as much as 1.8 mb/d in the new year.

The strength of the agreement, which required considerable compromise, behind the scenes political maneuvering at the highest level, and some very creative arithmetic, has exceeded market expectations, with traders pushing up futures prices by around 10 percent. International benchmark Brent crude was last trading around $54.50/bbl and U.S. West Texas Intermediate (WTI) at about $51.50/bbl. While the math is a bit fuzzy, the agreement is nonetheless viewed as credible and constructive for higher prices. Oil analysts expect prices to trade in a higher range of $50-60/bbl in 2017 as lower OPEC oil output hastens the rebalancing of oversupplied markets. OPEC is hoping the new agreement will set a price floor of around $50-55/bbl, with a sustained price above $60/bbl seen a bit too high since it could spark a surge in nonconventional production, particularly U.S. shale oil.

OPEC is banking on higher prices more than offsetting the new lower production levels. A simple calculation shows OPEC daily revenue based on its reference production of 33.65 mb/d and a closing price for WTI of $45.25/bbl on November 29 equates to $1.52 billion a day while the new lower target of 32.5 mb/d and a price of $50/bbl generates $1.63 billion, or an extra $100 million a day and $3.1 billion a month. A price of $55/bbl will add an extra $265 million a day or almost $8 billion a month. OPEC producers have lost an estimated $1 trillion in oil revenue over the past three years.

High-Level Petro Diplomacy

The new agreement emerged from an unprecedented level of petro diplomacy by the improbable trio of Saudi Arabian Deputy Crown Prince Mohammed bin Salman (MbS), Russian President Vladimir Putin, and Iranian President Hassan Rouhani. For all three countries, the devastating financial impact from lower oil prices and the worsening economic outlook proved to be the uniting factor for a shared goal of getting a deal done, and enabled them to put aside divisive political considerations.

Political animosity between Saudi Arabia and Russia, already running high over the latter’s support of Riyadh’s nemesis Syrian President Bashar al-Assad, has worsened since Moscow has taken on a more aggressive military role in support of the Syrian government. At the same time, long simmering tensions between arch rivals Saudi Arabia and Iran have been escalating all year, and were behind the breakdown in OPEC and non-OPEC talks in April. Against the odds, Saudi Arabia and Russia, which along with the United States, comprise the world’s three largest oil producers, spearheaded the success of the agreement through the close contacts between Putin and MbS. Dialogue between MbS and Putin started when they met in September on the sidelines of a G-20 meeting in China. At the time, Russia and Saudi Arabia signed an agreement to cooperate toward balancing world oil markets.

Putin played a pivotal “intermediary role between Riyadh and Tehran,” according to reports from Vienna. It is understood that Putin weighed in with ally Iran to modify its position of insisting on reinstating its pre-sanctions quota of a 4 mb/d and 12.7 percent share of total OPEC production. The Iranian demands were rejected by Saudi Arabia, being a nonstarter for a major compromise. In the end, Iran climbed down from these demands but could still claim victory because it ended up with a higher quota than its current production capacity. For Saudi Arabia, which had already committed to shouldering a significant share of the cuts, Iran’s formal participation allowed the agreement to get done, which was the country’s overarching goal in its bid for higher revenue.

Saudi Arabia Driven by Economic Imperatives

Saudi Arabia, as expected, was the major catalyst driving the agreement, from pushing for a more ambitious production cut, to engaging Russia to participate and, in the end, providing just over 40 percent of the planned cuts. The kingdom’s more pragmatic and single-minded focus on finalizing a deal reflected its determination to improve the country’s economic outlook amid the devastating financial crisis brought on by two years of low oil prices.

Saudi officials were acutely aware that without an OPEC production cut agreement to spur oil prices higher, a worsening financial crisis in 2017 would plunge the battered economy into a deeper downward spiral. Led by the young, ambitious deputy crown prince, the kingdom is implementing aggressive fiscal reforms, budget cuts, and austerity measures to offset the plunge in oil revenue and recalibrate the economy to expand non-oil industries and services as part of its ambitious National Transformation Program and Vision 2030.

Government officials are trying to manage a delicate balance of fiscal cuts against the need to increase spending to spur economic growth but severe austerity measures, such as reducing salaries and benefits for government employees as well as removing some energy and electricity subsidies, have combined with sharply lower economic growth to whiplash the country’s weary population. The revenue boosting agreement will provide some breathing space by allowing government officials to slow the pace of austerity measures as well as inject more money into the economy.

Playing Hardball

Even with the three influential powers throwing their weight behind the agreement, getting all members on board was a bit like herding cats. OPEC reached a tentative decision to reduce oil output in response to the slow pace of market rebalancing and continued weak oil price outlook at its meeting in Algiers in late September but left the final details of the agreement to be worked out at its biannual ministerial meeting on November 30. Fine-tuning the deal, though, has been fraught with challenges.

Despite a series a meetings over the past few months among OPEC delegates to thrash out the details, the final pre-conference gathering failed to overcome differences after 10 hours of talks. As a result, going into the November 30 meeting, competing demands for special considerations left the group unwilling to commit to individual country quotas. To break the impasse, Saudi Arabian Energy Minister Khalid al-Falih called his Russian counterpart Alexander Novak the night before the meeting and extracted a commitment for a 300 kb/d cut rather than the more modest proposal to just freeze production. Falih used this unexpected and significant contribution to persuade members to agree to hard numbers for their own production curbs, which paved the way for the final accord.

The final deal cobbled together is far from straight forward but nonetheless is largely viewed by oil market analysts as credible, especially since it includes individual production targets for most members as well as the establishment of a committee to monitor compliance. On the negative side, some of the number crunching used to satisfy various demands is less than orthodox. The basic parameters of the deal call for a 4.5 percent reduction for 10 of OPEC’s 14 members, with strife-torn Libya and Nigeria exempt from the agreement, Indonesia’s membership suspended, and some complex calculations that see Iran’s target actually higher than its production capacity. Nonetheless, the implementation of proportionate cuts for most countries was enough for Saudi Arabia to compromise on a number of the other issues. Saudi Arabia’s key demand was that the burden of reducing production be shared equitably.

The most glaring problem related to OPEC’s announcement that production would be reduced to a quota of 32.5 mb/d is the fact that once individual country allocations are added up, the total target actually works out at a higher 32.68 mb/d. Nonetheless, the market largely discounted this discrepancy, in part because analysts and traders expected the cut to be lower than the final number based on the group’s history of weak compliance with previous accords.

However, even building in a smaller cut of 1 mb/d, analysts predict the agreement will accelerate a rebalancing of the market. If OPEC manages to reduce production to its 32.5 mb/d target, preliminary calculations show demand outpacing supplies to the market in the first quarter of 2017. With oil demand currently forecast to rise by 1.2 mb/d to 96.8 mb/d in the first half of the year, stocks look set to decline by 400 kb/d to offset lower supplies. Assuming OPEC maintains is lower production levels for the second half of the year, and adjusting for an increase in U.S. shale output of 300 kb/d in response to higher prices, the drawdown will gather pace through the year, to an estimated 800 kb/d in the third quarter and by as much as 1 mb/d in the fourth quarter.

Crunching the Data

On paper the agreement calls for a collective cut of 1.16 mb/d but market watchers are forecasting the actual reduction will be lower, at between 850 kb/d and 1 mb/d. Crucially, OPEC’s Gulf members are slated to provide just under 70 percent of the cuts, or a combined 786 kb/d, and analysts expect 100 percent compliance given their track record.

OPEC used October data as reported by secondary sources and published in its Monthly Oil Market Report as a reference point for production for most countries. Iraq and Iran initially objected to using the secondary source productions as a reference basis, arguing the estimates were too low but in the end compromised on the issue. As expected, there are a few exceptions, with Angola’s reference level based on September production since its October output was exceptionally low as a result of scheduled field maintenance. New quotas for Libya and Nigeria are simply based on estimated October output but volumes are expected to rise over the coming six months, which could potentially add as much 500 kb/d, bringing the total from 32.5 mb/d to 33 mb/d.

To meet Iran’s demand that the country would not reduce output but satisfy Saudi Arabia’s insistence it be seen as part of the new deal with an assigned quota, the country’s reference level was backdated to mid-2005, when output reached 3.975 mb/d before sanctions eroded its production. Applying the 4.5 percent cut to the artificially higher level equaled a notional cut of 178 kb/d, or a final quota of 3.797 mb/d, which is still some 90 kb/d above actual production of 3.69 mb/d in October.

Iraq had been arguing strongly that it should be exempt from any agreement because of the massive cost of its war against the Islamic State in Iraq and the Levant and that it was shouldering the financial burden to the benefit of the entire region. Iraq also strongly objected to the use of secondary sources for estimates of its production, arguing they were too low. In the end, Iraq’s Oil Minister Jabar Ali al-Luaibi called Prime Minister Haider al-Abadi to get a green light for a new lower production level. Abadi reportedly told him to “get the deal done.” After the agreement was reached, Abadi said that they had calculated that every $1/bbl increase would add $1 billion to Iraq’s budget. Haitham al-Jabouri, a member of the Iraqi Parliament’s Financial Committee, said Iraq won’t change the planned 2017 budget after the OPEC agreement but instead will use the expected increase in revenue to reduce the projected $18 billion deficit.

Russia Set to Join in with Cuts

During the Vienna deliberations, Moscow committed to delivering half of the 600 kb/d of non-OPEC production cuts. OPEC President and Qatari Energy Minister Mohammed bin Saleh Al-Sada told reporters that Moscow reaffirmed to him its commitment to reduce production by 300 kb/d in a phone call during the meeting. Novak said he expects the country’s major producers to participate in the cut. Despite promises in the past to do so, Russia has never complied with its commitments to OPEC. This agreement with Russia to reduce output would be a first. A Russian energy source told Reuters: “Putin wants the deal. Full stop. Russian companies will have to cut production.”

Less clear is what other non-OPEC producers will contribute. OPEC will hold talks with non-OPEC producers to reach an agreement on specific production cuts, scheduled for December 10 in Vienna. Other non-OPEC countries scheduled to attend include Azerbaijan, Kazakhstan, Mexico, Oman, and Bahrain, which combined are expected to contribute a further 300 kb/d. Mexico’s  production is expected to fall on natural decline rates anyway in 2017, by 215 kb/d to 1.944 mb/d, so it will likely argue it is already making a contribution.

OPEC Casts a Wary Eye on Shale Oil Production

The new agreement, for all its flaws, has won over the market, though there are still plenty of skeptics who argue the accord will unravel due to a lack of compliance, or a surge in shale oil production. In the past, OPEC has been successful, to varying degrees, in implementing production agreements during periods of acute financial crises, such as in 1998 and 2008, and the current market is even more damaging for governments’ oil revenue. The prospect of oil prices falling below $40/bbl also figured significantly in efforts to reach an agreement.

With the hard work done now, both OPEC and oil analysts will shift their attention to the response to higher oil prices by U.S. shale producers, which some OPEC analysts fear could undermine the agreement. Before the agreement, analysts had forecast a recovery in shale production of around 200-300 kb/d in 2017. Higher prices are expected to see an upward revision to these projections, ranging anywhere from 300 kb/d if prices hover around $50-55/bbl in 2017 to a stronger 500-600 kb/d if they reach $60/bbl. More optimistic analysts argue that given projections of increased global oil demand growth of 1.2 mb/d in 2017, the market can accommodate higher shale volumes. OPEC will meet again in May 2017 to review the market and discuss a possible six-month extension of the deal.