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Opec - now for the hard part

Opec's Algiers deal has put a floor in prices - but the group must give the market real details at its end-November meeting

Trading on faith if not a suspension of disbelief, oil prices have found a floor at about $50 a barrel. Short of a major geopolitical shock, a price surge is not on its way. But the Opec deal announced at the end of September has wiped out many of the market's shorts. Now, to keep some modest price momentum-and the bears at bay-the group must deliver real cuts with real details at its Vienna meeting on 30 November.

Start with the obvious. Saudi Arabia's change of tack is not a head fake. The kingdom's new oil minister, Khalid al-Falih, has been signalling since the last Opec meeting in June that he wanted to reanimate the group and restore its purpose. The kingdom's economy has weakened, its fiscal pressures have deepened, its stock exchange has plummeted-all because of the oil-price drop since 2014. It wants to privatise some of Aramco, lift fuel subsidies and reform the economy. Higher oil prices will help with each aim. The policy change, back to supply management, is real.

But policy and execution are not the same, and Opec's history lends credibility to sceptics who foresee another fudge emerging at the end of November.

It is still unable to send a clear message-and the lack of clarity is dangerous to the organisation's own aims. Saying the group will cut, later, to between 32.5m barrels a day and 33m b/d, was a move straight out of Opec's compromise factory. Producers will always aim for maximum output. Far better would have been to announce the lower number, even if it meant production came in higher. The output data would tell the market which members were adding, not cutting.

Instead, at the meeting in Algiers, Opec president and Qatari oil minister Mohammed al-Sada could only offer a vague pledge, leaving the big questions unanswered: how much Iran will produce; which members, aside from the Gulf countries, will cut; and how rising Libyan and Nigerian supplies might be absorbed.

The deal faces headwinds in this quarter too-especially as, because of nominations for cargo liftings, any cuts formally agreed at the end of November won't affect physical markets before the start of 2017. Between now and then bearish momentum could build as refineries enter maintenance, US inventory holders liquidate to avoid end-year taxes on stocks, and macro-economic worries resurface, not least the US Federal Reserve's impending interest-rate rise or a new banking crisis. Global oil-demand growth is weakening-the most recent International Energy Agency assessment for Q3 saw a rise of just 0.8m b/d.

Wall Street analysts, shocked at first by the Algiers deal, are now troubled by the opacity. Morgan Stanley says "scepticism is warranted". Citi says the deal was more rhetorical than meaningful. Goldman Sachs still expects oil prices to weaken through the end of 2016.

Foetal growth

Part of the problem is that the deal is premature and needs time in the incubator. It was achieved with some full-court-press diplomacy, all centred around persuading Iran to postpone its 4m-b/d output target, and rushed to satisfy the demands of host-country Algeria. Its oil minister Noureddine Boutarfa has been the intermediary in recent months between Saudi Arabia and Iran and his government desperately wanted a deal to be achieved on home soil. The prime minister, Abdelmalek Sellal, was brought in to put the screws on the group.

Algerian newspapers on 29 September proclaimed the triumph. "LE COUP DE MAÎTRE D'ALGER" ("The Algiers masterstroke"), shouted L'Expression, adding, wrongly, that Opec would now cut 1m b/d. "La Réunion d'Alger Rassure" ("The Algiers meeting reassures"), screamed the cover of El Moudjahid.

But for the few that expected some kind of deal, the outcome was much less than they hoped for. "It's an absolute disaster," said one seasoned Opec watcher from a major producer. Privately, Saudi advisors conceded their disappointment. To gain a real sustainable price surge, some insiders were calling for real and deep cuts. Instead of shock and awe, the market got hum and haw.

Still, the mood music at the Algiers meeting was significant. Sitting shoulder to shoulder in a small room at a briefing on 27 September, Falih and his counterpart from Russia, energy minister Alexander Novak, offered a united front. After the debacle of Doha last April, when Novak left the room in anger after Saudi Arabia canned a freeze deal at the last minute, getting Russia even back at the table wasn't easy. Since then, though, Vladimir Putin himself has put his name to a joint effort with Saudi Arabia to help oil prices.

That doesn't mean Russia is yet aboard. Vagit Alekperov, boss of the country's biggest private producer Lukoil, is an Opec sceptic, though he has talked hypothetically of accepting a protocol with the Russian energy ministry on freezing output. Igor Sechin, head of state-controlled Rosneft, insists his company will be increasing output in the coming months. He has been blunt about signing up to a deal with Opec: "Why should we do it?"

Novak said in the Algiers briefing that Russia would freeze its output if Opec's members could first agree among themselves. That leaves plenty of wiggle room.

Intra-Opec cooperation, after all, remains the sticking point.

Iran believes it can add another 100,000-150,000 b/d to its output in the short term, as new production from the West Karun fields comes online. And it still wants to reach 4m b/d, implying growth of more than 350,000 b/d.

Thinking with intelligence

So Saudi Arabia still has to decide if its desperation for a deal is so great that it can ignore Iran's ambitions. Iran has to decide if its 4m b/d goal-a political target, which many doubt can be reached as fast as Tehran says-is worth ruining Opec's best chance for an agreement in years. A deal that satisfies both sides is possible. But it will need some creative thinking.

Libya and Nigeria, which Saudi Arabia says will alongside Iran be treated as special cases in the deal, offer another headache. Mustafa Sanallah, chairman of Libya's state oil company, told Petroleum Economist in Algiers that work is now underway to restart production in the long-shut Sirte basin. The Waha field is already back on line and total Libyan output has doubled in a couple of months to about 0.58m b/d.

Sanallah is sticking to an output target that would raise it to 0.9m b/d by the end of the year.

On its own, Libya's rising production could more than fill the gap left by Opec's proposed cuts. More oil from Nigeria and Iran would overwhelm them.

Two other hurdles have appeared. Before cuts can be agreed, the members must decide baselines. Iraq and Venezuela both say the secondary sources Opec trusts to calculate monthly production levels underestimate their output. (Iraq has gone so far as to threaten reputable industry publications for misreporting its numbers.) To outsiders, this kind of nit-picking, when whole economies are at stake, looks almost comical. But within Opec, it's the kind of technical debate that can ruin months of diplomacy.

The second obstacle is the oil price itself. Paradoxically, if it rises too much in anticipation of a deal it could have the effect of wrecking it.

If Opec's members think prices are firming without their actually doing anything but talk about cuts, they'll feel less pressure to make the plan stick.

That would be disastrous, because if the group doesn't end 30 November with a credible deal the market reaction will be punishing.

So having recovered its reason to exist-cutting to support prices-Opec faces its eternal problem: enforcement. To make its new policy stick, it needs to tell the market who will be cutting and by how much.

It may need to go deeper than 32.5 b/d, let alone 33m b/d. And then it needs to hope the reaction from tight oil isn't immediately deflationary.

Above all, though, Opec needs to provide hard details, not vague assurances. Now that it has started to digest the undoubted significance of the policy reversal, the market will want real numbers from the meeting on Vienna's Helferstorferstrasse.

How a deal could work

Getting Opec's fractious members to agree on cuts is like herding cats. But the geopolitical rivalry between Saudi Arabia and Iran, enemies in proxy conflicts from Yemen to Syria, makes the negotiations underway now even harder.

Saudi Arabia has conceded that Iran will be a special case in the forthcoming supply deal. The details have yet to be worked out. Iran, though, has not yet abandoned its maximalist negotiating position: it wants to recover the 12.7% of Opec market share it held before sanctions.

Based on August's output of 33.237m b/d (the levels discussed in Algiers), that would entitle Iran to produce 4.173m b/d-output growth of another 0.52m b/d. In short, Iran's terms mean it would add to its output more than Saudi Arabia has offered to cut. Clearly, it's a deal-breaker for Riyadh.

But there's a way out of this impasse that gives both sides a victory. It depends on some trickery with the numbers.

Iran's 12.7% claim is based on its output from November 2011 (3.55m b/d) against group output then of 27.97m b/d. But that second number excluded Iraq, then still recovering from years of war and sanctions. Including Iraq, Iran's November 2011 of Opec output share was 11.6%.

Apply that 11.6% to August 2016's group-wide production from Opec (including Iraq) and Iran would be entitled to 3.85m b/d, or growth of another 200,000 b/d.

Alternatively, Saudi Arabia might recognise Iran's 12.7% demand, but insist it follows the same methodology used by Iran for its November 2011 number. That is, exclude Iraq from the August 2016 total. This would entitle Iran to 3.67m b/d.

That is within a whisker or two of Iran's actual output number in August of 3.65m b/d-or the equivalent of an extra VLCC every three months or so.

In other words, on oil the two sides aren't actually that far apart. Saudi Arabia could concede Iran's right to reclaim its old market share, but insist it measure like for like in terms of group-wide output. Bijan Namdar Zangeneh, Iran's oil minister, while maintaining a hard line in negotiations, has apparently said in private that he won't miss a deal "for the sake of 200,000 b/d".

It would, though, involve Iran conceding its urge to reach 4m b/d. The way to secure that is to put a time stamp on any Opec-wide deal, saying the cuts-and Iran's limit-would last for a year, or until market conditions approve. Such a compromise seems plausible: Opec insiders now say any deal will have a six-month time limit.

Assuming Iran accepted these terms-a victory in its market-share quest-Saudi Arabia's offer to cut 0.5m b/d could then be matched by an equivalent 5% cut from other Gulf members. In total, this would strip more than 0.8m b/d from supply.

Alongside Russia's freeze-conditional on an Opec agreement-and similar pledges from other Opec members, a deal on these terms begins to look plausible. It would also look significant for the market. Crucially, both sides would win something. Saudi Arabia could claim it had restored some Opec unity, stopped the surge in production from Iran, and cajoled Russia into a deal. Iran would have seen its market-share needs respected, while leaving the longer-term goal of 4m b/d in place for later.

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