Middle East Policy has been one of the world’s most cited publications on the region since its inception in 1982, and our Breaking Analysis series makes high-quality, diverse analysis available to a broader audience.
Omar Al-Ubaydli and Vassily Kuznetsov
May 23, 2017
In November 2016, OPEC’s obituary was ready, and geopolitics was a leading coauthor. If two of the most important OPEC members—Iran and Saudi Arabia—lacked diplomatic relations, how could they trust each other to adhere to production quotas?
By December, OPEC had pulled a rabbit out of a hat, delivering an agreement with nonmembers, including Russia and several other large producers. Even more miraculously, six months later, cheating has been minimal, oil prices have consistently exceeded their November 2016 level, and the agreement is poised to be extended. The key to the turnaround was the transformation of geopolitics from an impediment to an enabler.
By way of background, the economic barriers to a coordinated OPEC output cut are virtually insurmountable, because of the near-impossibility of cartel members objectively monitoring each other’s production. How could the likes of Angola and Ecuador keep tabs on each other? The financial gains from unilaterally reneging on output quotas are large, and the ease of covert noncompliance ensures that the temptation is too strong to resist. Consequently, cartels rarely get off the ground, and when they do, they quickly crash and burn.
Economists studying oligopolies have identified “ideal” cartel conditions: a small number (two to four) of producers with a high combined market share (80+%) and a homogenous cost structure, operating in close geographic proximity, in a market with stable demand. That’s basically the opposite of OPEC, whose twelve, geographically dispersed members have widely varying production costs, and account for less than half a market in which demand can be volatile.
The proof is in the pudding: from 1990 to 2009, OPEC members’ quota-compliance rate was 4%, and its members’ production was indistinguishable from that of nonmembers. The recently emerging intra-OPEC geopolitical rivalry was merely another nail in the group’s coffin. But what happened in late 2016? For the last twelve months, Russian oil minister Alexander Novak and his Saudi counterpart, Khalid Al-Falih, have been meeting in a very public fashion, reflecting a desire to increase strategic cooperation between the two countries. Their efforts have transformed OPEC’s weak hand into a reasonable one in several ways.
First, Russia is one of the world’s top three oil producers, and is an OPEC nonmember, so bringing it to the table immediately boosted OPEC’s effective market share by over 10%.
Second, several other OPEC nonmembers are countries over which Russia can exert influence, such as the former USSR states, further expanding the group’s collective market share.
Third, Russia’s relationship with Iran can help OPEC overcome its internal political schisms. Russia’s influence over neutral members, such as Algeria and the South American producers, also helps.
With Saudi Arabia acting as the de facto leader of the Gulf oil bloc, arm-in-arm with a geopolitically potent Russia, the OPEC meeting went from being a multipolar, dysfunctional gathering doomed to repeat past failures, to a roughly bipolar meeting of partners, collectively accounting for a majority of global oil production. Not quite the poker equivalent of a royal flush, but something akin to trips—a fighting chance. And the oil price and quota-compliance data confirm success unheard of during the last 35 years.
What has been behind the desire to boost Russian-Saudi strategic cooperation? Economics has surely played a role, with falling oil prices hurting the Gulf kingdom, and global sanctions squeezing the Russian economy. However geo-politics has arguably played a bigger role. Russia has been trying to diversify its Middle Eastern foreign-policy tools, most prominently in Syria, where it has deployed both diplomacy and its military.
Meanwhile such activities in the region are supported by a number of Russian Muslim regional leaders, including Ramzan Kadyrov of Chechnya, who has developed relations with several Libyan armed groups and Caucasian communities in the Middle East. Oil diplomacy has become an integral part of Russia’s’ Middle East strategy.
Relations with Saudi Arabia have always been more complex, due to disagreements on various regional problems. Russia considers the kingdom to be one of the pillars in the Middle East security system and a driver of the world’s Islamic civilization, which includes 20 million Russian Muslims. Accordingly, Russia is very interested in fruitful cooperation with Saudi Arabia as a way of building mutual confidence. From Saudi Arabia’s perspective, its negative experiences with the Obama administration demonstrated the need to diversify foreign-policy tools as a national-security priority.
Until recently, the two countries’ similar economic structures were considered obstacles to cooperation, as it limited the potential gains from trade. However, the appearance of common geopolitical interests is contributing to a reversal of this negative tradition.
Despite this turnaround, all cartels, including this impromptu OPEC-non-OPEC alliance, are notoriously fragile. Moreover, persistent uncertainty over the technological capabilities of U.S. shale-oil producers mean that the Vienna agreement’s fundamentals remain quite weak. How long will producers maintain their discipline?
The good news for Russia, Saudi Arabia and their respective partners is that it need not hold for too long. Novak and Al-Falih are not trying to forge a new template for global oil production; they simply want to shift the supply glut that is keeping prices low. Investment in the industry has declined dramatically since mid-2014, ensuring a decline in future global oil production and a positive long-term outlook for prices. Astute geopolitics might help oil producers accelerate the balancing of markets. An improvement in mutual trust between Russia and Saudi Arabia will be a welcome corollary.
Omar Al-Ubaydli (@omareconomics) is the Program Director for International and Geo-Political Studies at the Bahrain Center for Strategic, International and Energy Studies, an affiliated associate professor of economics at George Mason University, and an affiliated senior research fellow at the Mercatus Center.
Vassily Kuznetsov is the head of the Center for Arab and Islamic Studies at the Institute of Oriental Studies of the Russian Academy of Sciences. He is also Associate Professor at the Faculty of World Politics of the Moscow State University.
Middle East Policy has been one of the world’s most cited publications on the region since its inception in 1982, and our Breaking Analysis series makes high-quality, diverse analysis available to a broader audience.
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Omar Al-Ubaydli and Vassily Kuznetsov
May 23, 2017
In November 2016, OPEC’s obituary was ready, and geopolitics was a leading coauthor. If two of the most important OPEC members—Iran and Saudi Arabia—lacked diplomatic relations, how could they trust each other to adhere to production quotas?
By December, OPEC had pulled a rabbit out of a hat, delivering an agreement with nonmembers, including Russia and several other large producers. Even more miraculously, six months later, cheating has been minimal, oil prices have consistently exceeded their November 2016 level, and the agreement is poised to be extended. The key to the turnaround was the transformation of geopolitics from an impediment to an enabler.
By way of background, the economic barriers to a coordinated OPEC output cut are virtually insurmountable, because of the near-impossibility of cartel members objectively monitoring each other’s production. How could the likes of Angola and Ecuador keep tabs on each other? The financial gains from unilaterally reneging on output quotas are large, and the ease of covert noncompliance ensures that the temptation is too strong to resist. Consequently, cartels rarely get off the ground, and when they do, they quickly crash and burn.
Economists studying oligopolies have identified “ideal” cartel conditions: a small number (two to four) of producers with a high combined market share (80+%) and a homogenous cost structure, operating in close geographic proximity, in a market with stable demand. That’s basically the opposite of OPEC, whose twelve, geographically dispersed members have widely varying production costs, and account for less than half a market in which demand can be volatile.
The proof is in the pudding: from 1990 to 2009, OPEC members’ quota-compliance rate was 4%, and its members’ production was indistinguishable from that of nonmembers. The recently emerging intra-OPEC geopolitical rivalry was merely another nail in the group’s coffin. But what happened in late 2016? For the last twelve months, Russian oil minister Alexander Novak and his Saudi counterpart, Khalid Al-Falih, have been meeting in a very public fashion, reflecting a desire to increase strategic cooperation between the two countries. Their efforts have transformed OPEC’s weak hand into a reasonable one in several ways.
With Saudi Arabia acting as the de facto leader of the Gulf oil bloc, arm-in-arm with a geopolitically potent Russia, the OPEC meeting went from being a multipolar, dysfunctional gathering doomed to repeat past failures, to a roughly bipolar meeting of partners, collectively accounting for a majority of global oil production. Not quite the poker equivalent of a royal flush, but something akin to trips—a fighting chance. And the oil price and quota-compliance data confirm success unheard of during the last 35 years.
What has been behind the desire to boost Russian-Saudi strategic cooperation? Economics has surely played a role, with falling oil prices hurting the Gulf kingdom, and global sanctions squeezing the Russian economy. However geo-politics has arguably played a bigger role. Russia has been trying to diversify its Middle Eastern foreign-policy tools, most prominently in Syria, where it has deployed both diplomacy and its military.
Meanwhile such activities in the region are supported by a number of Russian Muslim regional leaders, including Ramzan Kadyrov of Chechnya, who has developed relations with several Libyan armed groups and Caucasian communities in the Middle East. Oil diplomacy has become an integral part of Russia’s’ Middle East strategy.
Relations with Saudi Arabia have always been more complex, due to disagreements on various regional problems. Russia considers the kingdom to be one of the pillars in the Middle East security system and a driver of the world’s Islamic civilization, which includes 20 million Russian Muslims. Accordingly, Russia is very interested in fruitful cooperation with Saudi Arabia as a way of building mutual confidence. From Saudi Arabia’s perspective, its negative experiences with the Obama administration demonstrated the need to diversify foreign-policy tools as a national-security priority.
Until recently, the two countries’ similar economic structures were considered obstacles to cooperation, as it limited the potential gains from trade. However, the appearance of common geopolitical interests is contributing to a reversal of this negative tradition.
Despite this turnaround, all cartels, including this impromptu OPEC-non-OPEC alliance, are notoriously fragile. Moreover, persistent uncertainty over the technological capabilities of U.S. shale-oil producers mean that the Vienna agreement’s fundamentals remain quite weak. How long will producers maintain their discipline?
The good news for Russia, Saudi Arabia and their respective partners is that it need not hold for too long. Novak and Al-Falih are not trying to forge a new template for global oil production; they simply want to shift the supply glut that is keeping prices low. Investment in the industry has declined dramatically since mid-2014, ensuring a decline in future global oil production and a positive long-term outlook for prices. Astute geopolitics might help oil producers accelerate the balancing of markets. An improvement in mutual trust between Russia and Saudi Arabia will be a welcome corollary.
Omar Al-Ubaydli (@omareconomics) is the Program Director for International and Geo-Political Studies at the Bahrain Center for Strategic, International and Energy Studies, an affiliated associate professor of economics at George Mason University, and an affiliated senior research fellow at the Mercatus Center.
Vassily Kuznetsov is the head of the Center for Arab and Islamic Studies at the Institute of Oriental Studies of the Russian Academy of Sciences. He is also Associate Professor at the Faculty of World Politics of the Moscow State University.