In a significant policy reversal, OPEC members opted to revert to their traditional market management strategy of production targets to reduce the global oil supply glut during meetings that took place on the sidelines of the International Energy Forum in Algiers, September 26-28. The producer group reached a collective understanding on the need to reduce oil output given the slow pace of market rebalancing and the continued weak oil price outlook, but left the Herculean task of hammering out a binding agreement until the next scheduled ministerial conference on November 30 in Vienna.

Though finalizing a formal production accord in November is far from certain, OPEC’s “agreement” to pursue a more ambitious plan to cut production and effectively abandon its nearly two-year free market production strategy marks a major shift in policy. The massive surplus of global stocks weighed heavy on OPEC’s decisions in Algiers. In an official communique released following the discussions, OPEC said it “concluded that it is not advisable to ignore the potential risk that the present stock overhang may continue to weigh negatively well into the future, with a worsening impact on producers, consumers and the industry.” Without an agreement to reduce global supplies, the prospect of oil prices falling below $40 per barrel (bbl) loomed large over the gathering.

OPEC has faced two years of volatile oil prices that remain at less than half the $100/bbl levels posted in mid-2014. The prospect that prices would remain under pressure for another year united OPEC members in Algiers. The protracted downturn in oil revenue has cut to the bone of all member countries, with OPEC’s poorer African and Latin American members hardest hit, but even the more affluent Gulf states are struggling in the $40-45/bbl oil environment. Cash-strapped governments are turning to international markets for bond sales or loans from the International Monetary Fund to offset their budget deficits. Governments are implementing a wide range of fiscal constraints and unpopular austerity measures including slashing energy subsidies, reducing salaries for civil servants, and cancelling or postponing major development projects. International oil companies have also sharply reduced operating costs and capital expenditures for exploration, development, and production, especially for the more expensive megaprojects in non-OPEC countries.

Maximizing Revenue Trumps Market Share

Saudi Arabia, which championed the market share strategy, reversed course in the hope that lower production by OPEC members would raise, or at least put a floor under, prices. The kingdom appears to have adopted a more flexible approach following the spring appointment of Khalid al-Falih as minister of energy, industry, and mineral resources. Indeed, a more unified OPEC emerged from the June ministerial meeting in Vienna following a coordinated diplomatic outreach to fellow members by Falih.

After three days of negotiations in Algiers, OPEC announced it would pursue a production target ranging from 32.5-33 million barrels per day (mb/d) – a cut of 200,000-700,000 b/d (kb/d) from its estimated level of 33.2 mb/d in August. OPEC‘s aim is to accelerate a drawdown of the stock overhang, bringing the market rebalancing forward from the end of 2017 to late 2016 or early 2017. Underscoring the significant progress made in Algiers, the informal discussions morphed into an extraordinary meeting of what is now formally the 170th (Extraordinary) Meeting of the OPEC Conference in Algiers.

OPEC’s agreement in principle to reduce production, however, was short on details and lacked clarity on a number of critical issues. As a first step, a high-level committee will be established to study production level scenarios for each member country and to make recommendations at the November meeting. OPEC also called on non-OPEC countries, including Russia, to reduce production “given the importance of cooperation among all major exporting countries to collectively balance oil markets.” In that vein, the new committee would also develop a framework for consultations between OPEC and non-OPEC producers.

Overcoming the final hurdle at the talks, OPEC officials acknowledged that Iran, Libya, and Nigeria would be treated as special cases given their recent history of production constraints, with Iran recovering from international sanctions and the others engulfed in political turmoil. Falih later told the media that the three countries will be allowed to “produce at the maximum levels that make sense.’’ The three countries are each hoping to raise their output by 400-500 kb/d from current levels.

Production from Nigeria and Libya has been disrupted by ongoing political unrest, domestic violence, and armed attacks on their respective oil surface facilities. The two countries have seen a sharp drop in their production levels, with Libya struggling to maintain output of 300 kb/d in recent months compared to capacity of 1.4 mb/d while Nigerian production has fallen to 1.5 mb/d versus a capacity of 1.9 mb/d. Libya has suffered the greatest losses but its ability to increase production in the coming year holds the potential to add as much as 1 mb/d of additional output to the market. Officials believe that production can rise to 600 kb/d by November and 900 kb/d by the end of the year. Western diplomats reached an agreement in mid-September with militia leaders to allow some ports to reopen and exports to resume. Libya’s chronic instability effectively allowed the Islamic State in Iraq and the Levant to establish a base in the country and increased oil exports are critical to fund military efforts to dislodge ISIL from the country.

In perhaps the biggest surprise to emerge from Algiers, Saudi Arabia and Iran reached something of a rapprochement, at least on thorny oil issues. In April, Iran said it would not join an OPEC agreement until its production returned to pre-sanctions level of 4 mb/d. In Algiers, Iranian Oil Minister Bijan Namdar Zanganeh reportedly said Tehran would join an agreement provided it was allotted 12.7 percent of OPEC’s gross production, or a level just exceeding 4 mb/d. Ironically, Iran’s production has stalled during the past three months at around 3.6-3.65 mb/d so its intransigence on receiving a much higher production allocation than its capacity was probably a factor in Falih ceding ground on the issue. Iran is projecting that it will add incremental production of 600-700 kb/d from the West Karun oil fields during 2017-18. However, industry analysts are forecasting that Iran won’t reach 4 mb/d until after 2020, with the new production coming online largely offsetting natural decline rates at the country’s older fields.

Saudi Arabia’s willingness to compromise in Algiers, especially with Iran, may reflect a more pragmatic approach to OPEC as it focuses on shoring up its revenue and tackles an array of economic issues on the domestic front. A decision by the U.S. Congress on September 28 to override President Barack Obama’s veto of a bill that allows relatives of the victims of the September 11, 2001 attacks to sue the kingdom for its alleged support for the terrorists also fueled concerns this week that the legislation may dent investor demand for the country’s first international bond issue slated for October. Saudi Arabia may delay the $10 billion-plus offering to allow time for market concerns to ease. Proceeds from the bond sale are expected to help offset the government’s budget deficit in the wake of lower oil prices as well as support economic diversification initiatives that are part of the National Transformation Program. Wall Street analysts believe the possible delay in the bond offering was an added impetus for Saudi Arabia to reach a positive outcome in Algiers.

Market Gives OPEC a Round of Applause

The prospect of OPEC reaching an agreement to cut production for the first time in eight years sent oil prices surging by $2-$2.50/bbl. OPEC’s strategy to increase market share in the face of rising competition from U.S. shale oil did, indeed, deliver tangible results in the form of lower non-OPEC supplies, which OPEC forecasts to decline by just over 600 kb/d in 2016. However, the relentless rise in global oil stocks over the past 10 quarters led to record levels of over three billion barrels, overshadowing and delaying a rebalancing of markets. The much anticipated rebalancing of markets has faced repeated delays as global production continues to exceed forecasts. In its latest market report, the International Energy Agency significantly revised its outlook, with a rebalancing of supply and demand not expected until late 2017 versus its earlier projection that demand would start outpacing supply as soon as the third quarter of 2016.

OPEC’s proposal to reduce production to a lower 32.5-33 mb/d range will theoretically accelerate the rebalancing, based on current International Energy Agency fundamentals and industry estimates. Instead of projected stock builds in 2017 of around 700 kb/d in the first half of the year and 100 kb/d in the second, holding OPEC output at 32.5 mb/d will lead to a stock draw of around 400 kb/d through June and a steeper 1.1 mb/d for the remainder of the year. Of course revisions and more complete data make the timing a moving target, but directionally OPEC’s plan will bring forward the rebalancing to early 2017.

Standard Chartered Bank estimated in its “On The Ground” report that, even without OPEC cuts, a rebalancing of supply is already underway. The report emphasized that the market may be underestimating the impact of robust demand growth on market rebalancing. “Demand has been five times more important than North American supply in rebalancing, and has compensated for all of the surge in OPEC output. Without that demand strength, we think that the so-far partial recovery of oil prices would have taken far longer, and been accompanied by even greater financial and economic pain for the industry and exporting countries.”

Underscoring it bullish outlook, Standard Chartered said it expects demand will remain strong next year, forecasting growth of 1.43 mb/d, taking it above 98 mb/d by the end of 2017. “Should that happen, we expect global demand to not only exceed supply, but to also exceed global supply capacity, significantly accelerating the rise of prices,” the report noted. “As a percentage of demand, global spare capacity is at an historic low. We think that current inventories are nowhere near large enough to compensate for both lack of spare capacity and a multi-year supply squeeze due to low investment.”

Can an Agreement be Concluded in Vienna?

OPEC’s record over the past five decades demonstrates that the most difficult obstacles in reaching an agreement are the multitude of competing demands from member countries. OPEC unity is relatively easy when reaching a broad consensus on the need to reduce production, but finetuning the details is an arduous task as individual countries strive to protect their national interests. Even basic details are difficult to determine, such as what should be the starting production base, can a pro-rata cut be implemented successively, how to deal with those countries that ask to be exempted, and how to ensure transparency. The issue becomes even more complicated when member countries are experiencing major geopolitical conflicts.

As a result, while markets roundly applauded OPEC’s achievement in Algiers by bidding prices higher, the group’s history of contentious debates that ultimately sabotaged agreements at the 11th hour have many analysts questioning the group’s ability to close the deal in November.

Russia apparently shares that skepticism and has made it clear to OPEC that its cooperation with the organization is conditional on OPEC’s members adopting a common policy to reduce production. While it is imperative for OPEC member states to formalize new production targets in order to bring Russia on board, Moscow has not indicated if it intends to curb its production. Russian oil production in September reached its highest level in the post-Soviet era of 11.1 mb/d, up 400 kb/d from August. Russian President Vladimir Putin and Saudi Arabia’s Deputy Crown Prince Mohammed bin Salman met on the sidelines of the G20 meeting in China to signal their support for cooperation, which was followed by Falih and his Russian counterpart Alexander Novak signing a memorandum of understanding to set up a working group to study the market. Following the OPEC meeting in Algiers, Novak said consultations with OPEC would take place over the next several months to discuss possible joint action.

OPEC reached an important consensus to put an end to market instability and may have averted another price crash. Proposals to reach this decision necessitated intensive discussions and compromise. Nonetheless, further differences are likely over the remaining details that need to be ironed out.