Challenges loom for producers to stabilize the oil market

Oil prices are down 70 percent since 2014.

Companies and countries are responding to what has become the new mantra about prices — "lower for longer." Six months ago, prices were around $40 a barrel. But in recent weeks, they seemed to be riding down a wave of negativism toward what some said would reach $20 or even $15. But with the new discussion of an output freeze by exporters, sentiment has turned somewhat — and so, for now, has the price, at least a little.

But prices are still down 70 percent from 2014, and companies have had to adopt "lower for longer" as their planning assumption. Managements may believe that the market could stabilize later in 2016 or 2017, but the prudent policy is to cut budgets further, shore up the balance sheet and, as one CEO put it, "ride out the storm."

This past week, IHS Herold identified an average of 51 percent cuts in 2016 budgets in a group of major independents, from 2015 budgets that themselves had already been cut from 2014 levels. This is why U.S. production, while surprisingly resilient since the price collapse began, will nevertheless continue to decline.

Floor hands work on an oil rig in the Bakken shale formation outside Watford City, North Dakota.
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Floor hands work on an oil rig in the Bakken shale formation outside Watford City, North Dakota.

For many countries, the loss of revenues means not only tough political decisions and economic hardship but also threats to social stability. Yet, with the reaffirmation last December of the OPEC decision to do nothing and leave everything to the market, it seemed that the producers would not intervene with a deal, as they had done during the previous price collapses of 1986, 1998 and 2008. Still, the strain caused by low prices was evident in a meeting at Davos a few weeks ago. When it was remarked that hedges by U.S. producers would run out in 2016, the prime minister of one major oil exporting country became agitated and wanted to know in exactly which month.

The insurmountable obstacle to a deal this time has been over who would and who would not make the cuts. Saudi Arabia and the other Gulf exporters contend they will not be the only countries to reduce production; they would not surrender market share and make room for others to increase output.

Yet the day of reckoning has finally pushed exporters to search for some way to stabilize the market. But this freeze should not be confused with a cut. It is a status quo — holding production constant with the expectation that rising demand, plus production declines in some countries, will help bring the market back into balance.

"The talk of a freeze has certainly shifted sentiment in the oil market away from abject pessimism, and it could end up being the bridge to stabilization. But it leaves the big questions."

Since 2014, the Gulf producers have made clear that they will only agree to some deal if all exporters sign up. Russia has repeatedly said it does not have the mechanism to cut production. But now Russia, under even greater budgetary pressure, is on board, agreeing to freeze production at the January 2016 level. It is now easier for Russia to make such a promise, for low prices have imposed their own ceiling on Russian output, which would in any event be flat or even decline in 2016.

But discussions so far are only, as Saudi oil minister Ali al-Naimi put it, "the beginning of a process." Iraq, whose production has soared in the last few years, has indicated it would sign on. But one country is missing: Iran. Here is where geopolitics comes into the equation. Normally, geopolitical tensions would drive prices up, as they did, as late as June 2014, when an ISIS advance toward Baghdad sent prices soaring to $115 a barrel. This time, however, geopolitics is having the opposite impact. Indeed, what happens to the oil price is subordinate in part to the high tensions between Saudi Arabia and Iran.

As the Arab Gulf producers see it, Iran is embarked on a campaign to become the preeminent power in the Middle East. They point not only to Shia-dominated Iraq but to Syria and to Yemen, where they are engaged in what is seen as a proxy war with Iran. Whatever the prospects for a U.S.-Iran detente in light of the nuclear agreement (Iran's supreme leader Ayatollah Ali Khamenei says "absolutely not"), the agreement does mean the return of sanctioned Iranian oil to the market and a battle for market share by the cross-Gulf rivals. And the Arab Gulf countries are determined not to reduce their output in order to facilitate Iran's capture of markets.

Tehran's response to a freeze has been ambiguous. Recovery of market share has become manifest destiny for Iran, and Tehran would hardly endorse any freeze on the cusp of Friday's critical parliamentary elections. Saudi Minister Al-Naimi has said that the working out of a freeze could take several months. That would provide enough time to ascertain how much additional volumes Iran is actually able to put into the market and also at what level it might thereupon sign on to a freeze. Over the weekend, however, Alexander Novak, the Russian energy minister, took a different tack, saying that the freeze could go into effect much sooner, even without Iran.

The talk of a freeze has certainly shifted sentiment in the oil market away from abject pessimism, and it could end up being the bridge to stabilization. But it leaves the big questions. Will the market come back into balance later in 2016 or in 2017? And what will that mean for recovery in oil prices? Whatever the timing, if the unusually close correlation persists between stock markets and oil prices, that would mean a new reckoning and one that would be welcomed by financial markets as well.

By Dan Yergin, vice chairman of IHS

The oil market uncertainty expressed by Yergin in this commentary is the context for this week's IHS CERAWeek 2016. CNBC will be on the scene covering the 35th IHS CERAWeek conference in Houston, with many of the biggest names in oil on the program. The annual energy conference features 300 speakers, including the petroleum minister of Saudi Arabia, the chief technology officer of Tesla, the executive director of the IEA and the Secretary General of OPEC.