To Freeze or Not to Freeze: Why Are We Still Asking this Question?
This weekend the world’s major oil exporting economies will meet to discuss the status of global oil markets and once again contemplate the idea of limiting their own production at current levels (known as freezing production) in order to support higher prices. More than two years into the latest oil price downturn and energy watchers are all still wondering when the market will recover. As several of my colleagues wrote a few weeks ago, supply and demand are coming back into balance, but oil prices are still likely to fluctuate given the ample crude and oil product supplies in storage, the resilience of supply coming onto the market, and the continued presence of lackluster demand figures.
Given this backdrop of uncertainty, oil prices have proven quite quick to move according to market sentiment. Falling production numbers, increased demand reports, stock drawdowns, and supply disruptions all have the potential to move the market a few dollars for a brief period of time. It is in this context that OPEC members and Russia have taken advantage of the ability to collect a bit of much-needed revenue by talking about capping or “freezing” their own production in an effort to stabilize markets. Each time the group, or more often members of the group, have rumored an agreed upon freeze, the market responds with a small increase in price.
So is this talk of a freeze all for show? Not necessarily. At some point OPEC producers may be ready to negotiate a production freeze when conditions are right. There seem to be three likely conditions that need to be met, but each is a bit squishy. The first condition is that all major oil producers have reached their realistic production level (not their aspirational future capacity target or some inflated level at which they’ve been producing recently—a point that they have mostly achieved). This means Iran, Iraq, Saudi Arabia, and Russia (though not an OPEC member) will have to be producing at or near their production potential limit. These latest talks reportedly show a widening gulf on expectations here—with Saudi Arabia proposing a cut for a lower threshold production freeze from Iran, Iran proposing a freeze at higher levels of production than they have today communicated as a percentage of OPEC output, and Russia deciding not to negotiate until OPEC has settled its internal matters—all broadly in line with where these players have been. The second condition is that the market will need to be on the road to recovery with the underlying fundamentals to support a longer-term price recovery. This is a particularly squishy condition because a price increase can erode the “recovery” by putting more production on the market from U.S. tight oil producers and perhaps weaken demand. The third and final condition is that producers currently producing below historical highs would need to be taken into consideration in one way or another. Libyan oil supply has been going up and down like a yo-yo over the last several years due to its domestic instability; Venezuelan production is on a steady decline; and Nigerian production is suffering from domestic sabotage. The world’s major oil exporters fall along a spectrum of fiscal breakeven oil prices, current economic distress, and proximity to their realistic near-term production capacity, each of which factors into their inclination to agree to a freeze.
Given these conditions it has been clear to many analysts that talk of a freeze up until now was, at best, premature testing of the waters to see how other members, and the market, negotiated around the idea of a freeze at some future date. Moreover, current market balances and the persistent oversupply in global oil stockpiles means that the freeze would have little to no effect on the actual physical market. Going into the meetings this week, the chances of a freeze were weak. OPEC secretary general Mohammed Barkindo said as much over the weekend, confirming what many in the market already concluded to be the likely outcome. So is all this talk of a freeze over? Not hardly, as it appears Mr. Barkindo’s comments were a setup for a more plausible chance of a freeze—the official OPEC meeting this coming November.
So what would the significance of a freeze be in November should it happen? Given the OPEC track record of adhering to production limits, the price responsiveness of tight oil production in the United States, and the still ample stock overhang, its impact on the actual supply/demand balance could be quite limited or, contrary to OPEC’s short-term interests, lead to an increase in U.S. production. On a more positive note, it could be an important signal to investors that OPEC members believe the market is actually on its way to a price recovery, which could in turn be a good signal for additional investment in the sector, an issue far more important than speculation about a potential freeze. As the International Energy Agency noted last week in its investment report, the world underinvested in energy in two fundamental ways: first, much of the investment went into things that do not align with a long-term low-carbon pathway, an important consideration in the fight against climate change; and second, upstream oil and gas investment fell by 25 percent in 2015 and is estimated to drop another 24 percent in 2016, a situation that could, if not remedied soon, lead to future price spikes and a lack of supply all else being equal. The price signal to spur additional investment will only be aided by a freeze if investors believe (a) it is more than just empty rhetoric, (b) OPEC did it based on their belief that a freeze would genuinely support prices and not out of desperation, and (c) underlying market fundamentals support the idea that the market is well on its way to some sort of recovery.
How many times can you cry freeze? As the boy who cried wolf learned once upon a time, you can only declare an intent to freeze and fail so many times before the market stops believing you. Perhaps this is why Saudi Arabia is purportedly suggesting a cut rather than a freeze to change market sentiment. OPEC’s task this time around is to make sure that failure to reach a freeze doesn’t have the opposite desired effect of leading to a price decline—something they can only do if they appear to have negotiated the bones of an agreement to take place at a later date.
Unfortunately, all of this does not address the longer-term questions of whether or not prices will ever be high enough, long enough to sustain many of the economies that are suffering under the current price environment, and what can and should be done to turn around their respective economic tailspins. Those are much tougher questions that few countries are able to tackle head on—which is why they keep taking about a freeze.
Sarah Ladislaw is a senior fellow and director of the Energy and National Security Program at the Center for Strategic and International Studies in Washington, D.C.
Commentary is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).
© 2016 by the Center for Strategic and International Studies. All rights reserved.