According to Reuters, "A spike in tensions between arch-rivals Saudi Arabia and Iran appeared on Sunday to ruin prospects of the first binding oil output deal in 15 years between OPEC and non-OPEC nations, and looked set to prompt another fall in the price of crude.” Oil officials are gathering today in the Qatari capital, Doha, to formalize an agreement to freeze production and normalize rates to January 2016’s output. The tensions are the consequence of Iran’s non-compliance in contracting into the agreement, but Azerbaijan's Energy Minister Natiq Aliyev claims that Iran supports the decision made by the OPEC and non-OPEC countries.
Therefore, the question that follows is: How do you exclude Iran, satisfy the Saudis, and maintain cordial relations with Russia? That’s difficult to parse, since if an agreement is not reached, the price recovery will be stymied and will return to a state of disrepair.
Mercurial oil prices also intensify the financial wounds of States where the cost of production is high and recovery margins are at historical lows. In the United Kingdom, for example, the constituents of costs include gross taxes, capital spending, varied production costs and administrative and transportation costs. Capital spending accounts for about half of the costs ($22.67 of $44.33 total barrel price). This is due to the oil’s location in stormy offshore waters and firms’ aging infrastructure. Therefore, when Brent crude is globally priced at $42.85, U.K. producers incur a loss.
Iran and Saudi Arabia profit margins are less harmed by afflictive production costs. In Iran it costs about $9.08 per barrel and in Saudi Arabia it only costs $8.98 per barrel. These countries don’t pay taxes, but firms in the United States do for U.S. non-shale, functioning as a major competitive disadvantage in the global market. This raises a host of issues for the U.S. as many new deep-plumbing projects come online, largely highlighted by last year’s high output. In the absence of a freeze arrangement, price competition ensues as firms sacrifice short-run profits to capture future marketshare. As other firms are forced to leave because they are undercapitalized and cannot finance short-term debt until prices readjust, the kingpins of OPEC profit at their expense.
Countries like Saudi Arabia, though, are graced by their location near the surface of the desert and the size of the oil fields, cutting transportation costs and plumbing costs since the reservoirs are not offshore. In the event of a freeze, Saudi Arabia will still yield a high marginal return on production. But consider the macroeconomic plights of Angola, a member of OPEC. Almost all of Angola’s export revenues are grounded in oil and, as a result, Angola is bedeviled by massive cashflow issues and is in need of financial resuscitation from the International Monetary Fund (IMF). If the price recovery is curbed by diplomatic fumbles and Iran’s inability to steward the freeze arrangement, then the de facto vulnerability of Angola’s public finances increases — no amount of structural reforms and fiscal discipline will bail them out.
There is still the issue of enforcing this agreement if it passes even if Iran is excluded. Cartels like OPEC profoundly rely on contract enforcement mechanisms and this agreement lacks them. A mechanism generally needs to be a credible threat. This may manifest as economic sanctions or the threat of war. But, as Saudi Arabia has credibly threatened, it will commence selling its USD treasury reserves. The true quantity of shares is unspecified since the U.S. does not disclose the amount for Saudi Arabia. This functions as a satisfactory threat since the liquidation of these treasuries would have unsettling consequences in Western geopolitics and global markets. Moreover, other States, like Russia, may diversify away from USD assets and monetize other nations’ debts instead of ours.
When Iran chooses not to attend meetings in Doha, the price is whipsawed. When Iran decides to send a lowly minister to the meetings for cordial reasons, the price rebounds. New York Times headlines are determining the price of oil instead of the traditional notions of supply and demand. Bank of America analysts claim that regardless of a freeze, the decrease in U.S. supplies and mild increase in global demand is rebalancing the market and normalizing prices. However, if Iran is excluded from the agreement and begins to price out smaller, resource-cursed nations like Angola, the oil supply market will begin to change.
