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Moscow rules

The fate of the relationship with Russia will be critical as balances tighten and competitor output builds

Saudi Arabia's new-found diplomatic bond with Russia will remain at the core of Opec's efforts to drain oil stocks in 2018. Cuts will likely be extended again, possibly to the end of the year, as non-Opec supply out-strips demand growth, reducing the need for the group's own oil.

Saudi Arabia and Russia together account for more than 20% of global supply and are both titans of the oil-exporting world. Crucially, both also have either spare capacity or a proven ability to expand oil production in the medium term. So their joint determination to see through the output cuts agreed in late 2016 should be taken seriously.

The partnership appeared tentative early on. But following King Salman's autumn visit to Moscow, the Saudi-Russia axis looks less like a temporary marriage of convenience and more like an enduring political alliance. By combining bilateral investment and regional political coordination alongside the Opec track, Moscow and Riyadh have sent a strong signal to markets about their joint commitment to the deal.

For Russia, the price paid for an alignment with Opec has been inexpensive: cuts of just 250,000 barrels a day is more a story of growth foregone than a scaling back of exports. In return for this, Moscow has won a seat at Opec's top table and an outsized influence on the organisation's policy and direction. Even so, it's difficult to see the quotas lasting beyond 2018. Either the cuts will achieve their stated aim and Russia will look for the exit—or the prospect of the 2016 deal becoming "permacuts", or structural, will force a reappraisal in the Kremlin, where market share for oil and gas remains an overriding strategic objective.

It's possible to paint scenarios for 2018 that see oil prices exceed the 2017 highs

But by limiting the cuts, Opec has set the bar low. By handing out exemptions and keeping cuts moderate, the organisation can claim 100% compliance or even better in 2018. Deferring a cargo or two allows Saudi Arabia to make up for leakage elsewhere. Despite warning that it would no longer carry the burden of cuts alone, the kingdom continues to be the cutter of last resort. If the cuts continue through 2018, so Saudi Arabia will continue shouldering their bulk.

Compliance in any case will get less relevant—many Opec member countries that were known for poor compliance in previous cuts are now themselves constrained by declining capacity due to reduced capex, political unrest or mature oilfields that are past their peak. In this group, historical quota-busters Venezuela and Nigeria face a struggle to maintain capacity in 2018, absent positive political breakthroughs that would allow the re-entry of external capital and technology. Even Iraq and Iran, two of the Middle East's largest oil reserve holders, are facing fresh political pressures that will put expansion plans on the backburner and could see them struggling to lift productive capacity beyond 2017 levels.

If these countries can no longer upset the apple cart, the focus inevitably shifts more closely to what the big Gulf producers say and do. The messaging in favour of an extension of the cuts to the end of 2018 has been unusually consistent and this should be enough, other things staying the same, to put a price floor under crude, holding benchmark Brent prices above $50 a barrel.

Moreover, if the balance of risk points to supply disruption rather than over-production or cheating, then it's possible to paint scenarios for 2018 that see oil prices exceed the 2017 highs. Spare capacity within Opec mostly resides in the big Gulf Cooperation Council producers: Saudi Arabia, Kuwait and the UAE. These three could supply an additional 1m b/d at a push—but beyond that, replacement barrels from Opec will be hard to find.

So fresh problems in Libya or Nigeria—two of the countries where domestic unrest has had profound implications for oil production—would force Gulf countries to max out at capacity. Add into the mix a possible shutdown in Venezuela, deterioration in Iraq, or the potential for new US sanctions hitting the Iranian oil sector and the stage is set for higher oil prices.

While these bullish scenarios will be welcome to those producers seeking higher oil prices, they present their own set of hurdles. First, the extent to which non-Opec supply will respond to rising prices remains unclear, but the wave of producer-hedging observed when WTI topped $50 in September 2017 suggests that many American shale producers will have been content to lock in that price for 2018. Rising tight-oil output when prices are above $50 is a given—but the speed and scale of their response to a firming market will decide whether the Opec's cuts deliver a durable, higher price range.

Exogenous risks also exist in the form of the oil demand outlook. Unexpectedly strong demand in the second half of 2017 surprised markets at the time, but a return to a higher level of demand growth in 2018 and beyond seems unlikely. Notwithstanding the IMF's optimism about global economic growth, China's credit-heavy mini-boom and frothy global stock markets have prompted some to warn of a new asset bubble that's ready to burst in the next year. The tapering of special measures by central banks led by the US Fed could also undermine the liquidity that has shielded the industrialised world from uneven growth. A normalisation of interest rates could hit auto sales, for example, which are already under pressure as consumers eye government policies aimed at reducing reliance on the internal combustion engine.

But Opec also faces a more basic problem much closer to home. Producer economies within the organisation have yet to adjust to oil prices at $50—and signs that they will in 2018 are scant. This is never explicitly acknowledged, but is evident from their desire to extend the Opec cuts and shoe-horn prices back to the $70-80 zone. Neither their oil industries, nor public sectors which depend on oil revenue, are fully financed at present prices and will continue to create fiscal deficits until deep economic reforms are enacted. While Russia postponed a reckoning thanks to the ruble devaluation in 2014-15, Opec oil producers will need to do more if they're to match the progress made by commercial oil companies in shedding cost.

Without those reforms, producers may discover that the higher oil price they seek is incompatible with a stable oil-market share over time, let alone the growth that they, as low-cost producers, have aspired to. Higher oil prices will accelerate growth from unconventional oil plays, deep-water and even Arctic conventional oil projects. A spread sideways of capital and technology into new tight-oil provinces outside North America will drive this shift even faster.

For oil prices, these challenges are long-term bullish: producers who fail to adapt to the new marginal cost of oil production will face economic and social decline, in turn imperilling the operation of the oil industry upon which their economies have been built. Already that pattern has emerged to varying degrees; and there's scope for it to spread and deepen within the group.

Finally, the progress of alternative energy within the transportation sector—a long-term threat out of Opec's control—should be watched closely. Many countries and cities now see a future free of the internal combustion engine. If the writing is on the wall, Opec is looking the other way, convinced that heavy-goods trucks, ships and aircraft will remain unassailable as a growth market for oil. Of course, in the short or medium term that's correct. But the long-term prosperity of the Opec countries depends on acknowledging the shift and preparing for it. The timing and scale of future Opec oil investments will depend upon that.

This article is part of Outlook 2018, our annual book looking at energy market trends for the year ahead. To purchase a copy, click here

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