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Saudi Arabia and Russia Just Threw the Oil Market With a Big, Fat Head Fake

Key Speakers At The World Economic Forum (WEF) 2016Key Speakers At The World Economic Forum (WEF) 2016
Khalid Al-Falih, Saudi Arabia's Oil Minister.Photograph by Matthew Lloyd — Bloomberg via Getty Images

Crude oil prices rocketed, then fell back almost as precipitously, on Monday after big-sounding promises about restraining output by the world’s two largest producers—Saudi Arabia and Russia—turned out to be little more than big words.

U.S. crude futures surged nearly $2.50 a barrel to a high of $46.53 after Saudi media promised a “significant announcement” about “cooperation to support oil markets.” Russia’s energy minister Alexander Novak, for his part, promised a “historic” declaration. Coming on the day after Saudi and Russian officials had talked on the sidelines of the G20 summit in Hangzhou, China, traders leaped to the conclusion that a long-awaited agreement to freeze crude output at current levels would be announced. Hadn’t Vladimir Putin himself said just before the meeting that this would be “correct from the viewpoint of economic sense and logic”?

But by morning in America, futures had given up over half their gains: the promised deal consisted of little more than the setting up of a talking shop, or “joint working group” to “monitor fundamental indicators on the oil market and develop recommendations on measures and joint actions to guarantee the stability and predictability of the market.”

In short, lots of supportive words, but no guarantee of any restraint at all when OPEC’s ministers meet (informally) in Algiers later this month.

“Freezing production is one of the preferred possibilities but it doesn’t have to happen specifically today,” Saudi’s Oil Minister Khalid al-Falih was reported by Bloomberg as saying. ”

Hopes had risen in recent weeks that the Organization of Petroleum Exporting Countries, after nearly two years of pumping as fast as possible to defend market share, would agree to freeze output to squeeze prices higher.

Prices have slumped by over half in that period, putting huge pressure on many exporters’ budgets: Venezuela is near bankruptcy, with repeated and large demonstrations against the Socialist government over shortages of basic goods; Nigeria is in recession after devaluing its currency, the naira, by 50% against the dollar; even Saudi itself has burned nearly $200 billion in foreign reserves to keep its own dollar peg intact. (It’s down to its last $560 billion now.)

Russian cooperation is vital to the success of any production freeze because it produces over 10% of the world’s oil. But Moscow has shown little or no desire to rein in its producer companies, most of which operate under direct state control. It has raised output by some half a million barrels a day since Saudi Arabia unleashed the price war in 2014.

So why the big fanfare for so little in concrete terms?

The most likely explanation, says Georgi Slavov, an analyst at London brokerage Marex Spectron, is that they are making a virtue of out necessity.

“They are both operating practically at full capacity,” Slavov said. “There is no way they can ramp up their output further in the short- to medium-term.”

Al-Falih had said in June that Saudi’s total production capacity stood at 12.5 million b/d, nearly 2 million b/d above the 10.67 million it pumped in July, but said that this reserve would fall without investment. With prices stuck firmly below $50 a barrel, it appears that there hasn’t been enough left over for the necessary investment. Last week, he told Al Arabiya television that: “The market is now saturated with stored crude at beyond usual levels and we don’t see in the near future a need for the kingdom to reach its maximum capacity.”

There are other potential explanations, less tied to market minutiae. Jane Kinninmont, a fellow at the London-based Royal Institute for International Affairs, says today’s announcement still has a signaling value: “I think it is mainly about Saudi Arabia and Russia wanting to signal that despite their differences in Syria, their two governments are reaching out to each other to find areas of common interest—as this also sends useful signals to the U.S. and to Iran.”

“Saudi Arabia wants to remind the U.S. it has other allies, while Russia wants to avoid simply taking Iran’s side in all regional disputes,” with an eye to boosting its arms exports to other Gulf countries that have traditionally been rivals of Iran, she added.

With no prospect of a cut in supply at the Algiers meeting, the global market for crude is reliant on demand factors for its slow and irregular progress back towards equilibrium. Analysts at Barclays warned last week that investors risk missing the forest for the trees in reacting to the “headline of the day.” The big picture, they added, is that “a constructive oil market balance is emerging for Q4 2016 and 2017” as global demand grinds higher. They upgraded their average price forecast for Brent, the global benchmark blend, to $52 from $50 a barrel, accordingly. For next year, they now see an average Brent price of $57 a barrel, compared to $45/bbl this year.

By 1100 ET, U.S. crude futures were trading at $45.03 a barrel, still up nearly a dollar from before the market started trading on rumors of a deal. With most big U.S. accounts absent due to the Labor Day holiday, traders said the rest of the gains may quickly evaporate on Tuesday.