Oil and gas investors and the general public alike have every right to be confused this week given the flurry of activity and some actual positive oil news (warning – oxymoron alert!) that led to a mid-week rally in energy prices and shares.

Earlier this week, Saudi Arabia, Russia, Qatar and Venezuela announced a tentative pact to freeze production at current (albeit record) levels, provided that Iraq and Iran (and the rounding errors known as the rest of OPEC) agree to follow suit.

Markets were immediately schizophrenic about the move, with Brent rallying significantly, WTI staying flat for an extra day and pundits falling all over each other saying that this was just a bunch of tongue wagging, a head fake and that since Iran would never agree to it, it was meaningless and that a freeze isn’t a production cut when a cut is what is really needed, dammit and do it right now or else!

Interestingly, the market appears to have taken pause at this move and given it some thought. The interpretation being that maybe OPEC and some non-OPEC producers are nearing the “enough is enough” stage and are taking baby steps to address the issues that have been created by an over-supplied market (which of course they have contributed to). Of particular note, they accomplished by talking about not cutting production a price move equal to what a cut may have done.

Iran’s response of “we support these first steps, but we won’t freeze our production”, while confusing, is also somewhat constructive since they did not come out and say “you guys are nuts, there is no way we are going to agree with this”.

So in practical terms, what does this “freeze” actually mean? Remember back in December when OPEC removed its cap, we theorized:

“But, if you take the cap away altogether and let each country legitimately maximize production without a cap, you quickly establish what the upper bound of each parties’ productive capacity is and you can then re-allocate pro-rata quota based on actual full-pin production. Then, in June, when you meet again, assuming the oil market is still mired in the muck, you have a platform on which to establish a sensible and enforceable quota reduction.”

In essence, the proposed freeze is the re-establishing of the market cap and a precursor to more production oriented actions in the coming quarters. The major difference is that Saudi Arabia has somehow managed to tie Russia into the mix.

What is driving this to start happening now as opposed to any other time in the last six months is the headwinds all these petro-states are feeling. Downward revisions to global growth cutting oil demand growth, credit rating downgrades, China slowing, continued inventory builds, stubborn non-OPEC production. All these factors are keeping prices down for longer than appears to have been anticipated by OPEC.

And with everyone producing at record levels and the average realized price being lower from one month to the next, each month sees less and less revenue come into their countries for the same level of production – at some point it becomes too much and concrete action needs to be taken.

Russia and Saudi Arabia – strange bedfellows

The strangest part of this whole thing would appear to be Russia and Saudi Arabia being together in this given both their past history and current relationship. If anyone is old enough to remember the surpluses in the 1980’s and the late 1990’s, it was a joint OPEC/non-OPEC production cut that finally restored the market, except of course for the fact that really only Saudi Arabia cut production, the rest of OPEC cheated and Russia never did what they said they were going to do.

Fast forward to today, Russia/Iran and Saudi Arabia are clearly fighting a proxy war in Syria, so why in the world would they cooperate in any way, shape or form? Simply because they all need higher prices, both to support their war efforts (against each other granted, but no one really cares about semantics) and to buy off increasingly restive domestic populations stung by declining oil and gas revenues exacerbated by peak production in a declining price environment. It remains to be seen whether this admittedly counter-intuitive partnership can hold.

For Russia, the economic implications of the low oil price are significant. It benefitted last year from the cushion afforded by the collapse of the ruble, but that is a one-time event, the outlook for the Russian economy is bleak.

From Saudi Arabia’s perspective, the timing is perfect. They are producing at high levels, a little less than what they produced last summer during their peak demand season. They also have 2 million barrels excess daily capacity. They can either start to help the market now or put the beast down once and for all. It would appear they plan to keep their doomsday weapon parked for enforcement rather than use it.

What about Iran?

There has been a lot written about Iran and how they will be adding their million barrels a day of production by the end of the year and 500,000 a day as soon as the end of March, but how much of this is bluster and posturing and how much is reality? The answer is no one really knows.

Many people point to the 40 million barrels of crude that Iran has in storage and the recently loaded tanker bound for Europe and 160,000 bpd agreement with Total as a fresh sign that Iranian oil will soon flood the market, but as was pointed out at a recent presentation, Iran could have easily sold those barrels if anyone wanted them, but apparently about half that storage amount was a sour crude that isn’t in demand anyway. And that Total crude may be simply reallocating exports that they lost out to for China.

Also, should Iran actually bring their million barrels a day to market and collapse the market below $20 a barrel as Goldman insists, the government will be bring in less money with more production than if they had just done nothing. Thought of that way, it makes no sense. Never mind that they need massive investment to get there and with capex budgets being slashed across the board, the line to provide this capital to Iran is not terribly long. Not to mention that the fiscal terms for any foreign investment appear to be hung up in internal political purgatory for the foreseeable future.

All this to say, in the case of Iran, it is safest for them to play nice, go along with the flow and sell what they can as they will be able to move up the middle ground and gradually re-inflate their production to get their share of the market as others give ground.

The situation in Iraq is much the same as in Iran with a massive increase in production yielding diminishing returns and massive budgetary shortfalls.

So, why a freeze and not a cut? And what does it mean for Canada and the US?

For OPEC, North America (the US in particular) remains a problem. While the freeze might allow a gradual rise in prices, an OPEC production cut that causes prices to disconnect too quickly might embolden US shale producers, many of whom might be nimble enough or have access to capital to jump back into the market and upset the apple cart if prices re-inflate too quickly.

With the US rig count now officially off the proverbial cliff and on-shore, lower 48 US production declines finally gathering steam, the last thing OPEC wants to see is a rapid escalation of prices leading to runaway speculation in a market it cannot influence before substantial production declines in the US become a reality. For Canada, it is much the same as in the United States, albeit with a different product mix and perhaps a little less of a target on our backs.

So from a North American perspective, a freeze doesn’t change the dynamic of the market right away and allows the pain to continue for another quarter or so until production declines catch up and summer driving season chews up some of that excess continental inventory.

The talk of a cut may be enough of a price floor to sustain producers until the rebalancing actually takes hold.

Come to think of it, if they play their cards right, OPEC may never actually cut production.

Prices as at February 19, 2016 (February 12, 2016)

• The price of oil ended the week up
  • Storage was up marginally, finished product inventories remain high as refinery turnaround season is in force
  • Production was down
  • Markets continue selling the storage story.
  • The rig count decreased significantly
• Natural gas fell during the week, notwithstanding cold weather.

• WTI Crude: $29.90 ($28.99)
• Nymex Gas: $1.811 ($1.968)
• US/Canadian Dollar: $0.7261 ($ 0.7214)

Highlights

• As at February 12, 2016, US crude oil supplies were at 504.1 million barrels, an increase of 2.1 million barrels from the previous week and 78.5 million barrels ahead of last year.
  • The number of days oil supply in storage was 32.2, ahead of last year’s 27.5.
  • Production was down marginally to 9.135 million barrels per day. Production last year at the same time was 9,224 million barrels per day. The decrease in production this week came from the Lower 48.
  • Imports increased during the week
• As at February 12, 2016, US natural gas in storage was 2,706 billion cubic feet (Bcf), which is 26% above the 5-year average and about 23% higher than last year’s level, following an implied net withdrawal of 158 Bcf during the report week.
  • Overall U.S. natural gas consumption increased by 5.8% for the period led by residential consumption.
• Oil rig count at February 19 was down to 413 from 439 the week prior.
  • Rig count at January 1, 2015 was 1,482
• Natural gas rigs drilling in the United States were down to 101 from 102.
  • Rig count at January 1, 2015 was 328
• The continuing massive decline in U.S. rig counts continues to be a somewhat overlooked story given all of the OPEC related noise.
• As of February 16, the Canadian rig count was at 179 (28% utilization), 118 Alberta (28%), 35 BC (43%), 24 Saskatchewan (27%), 2 Manitoba (15%)). Utilization for the same period last year was about 48%.
• Offshore rig count was unchanged at 25
  • Offshore rig count at January 1, 2015 was 55
• US split of Oil vs Gas rigs is 80%/20%, in Canada the split is 53%/47%

Drillbits

• More companies are starting to report their Q4 and full year 2015 numbers and… it’s not pretty, unless of course you are in the pipeline business
  • Enbridge announced Q4 earnings of $378 million beating analyst expectations.
  • Interpipeline announced Q4 funds from operations of $211 million and full year FFO of $569.1, 32% ahead of the same quarter last year.
  • Devon Energy reported an annual net loss of $4.53 billion compared with $408 million last year and announced a fuirther 1000 job cuts to take effect in February
  • Enerplus reported funds flow of $103 million for Q4 and $493 million for the year. After non-cash charges, the company reported a loss of $1,523 million for the year. Most of the non-cash charges were one-time events.
• Drumpf Watch – Donald Drumpf continues to campaign in South Carolina, site of the next primary. Of particular note is a first for an election cycle, a fight with the Pope.