OPEC+ Shouldn’t Kick Russia Out Of The Group

The possibility that Russia will be asked to leave OPEC+, formally or de facto, reminds me of an old cartoon in which some OPEC members are threatened with expulsion and respond cheerfully, “You promise?” The reality is that the group exists to encourage (the polite phrase) exporters to reign in production whenever prices weaken. It is worth noting that all significant price increases in the past have occurred due to external events such as the Iranian Revolution or the Arab Spring, not members deciding they want higher prices. (I exclude instances where they acted to help prices recover after a collapse, as in 1999.)

The oil market and OPEC’s role in it are classic examples of the free-rider problem, namely that all producers benefit from actions of the group, which bears the entire burden. The organization has naturally struggled with compliance because cheating usually pays off: there are no formal sanctions for non-compliance and crashing the price is the only enforcement mechanism available. It’s not quite the nuclear option but members—and especially the Saudis, who are stuck with the role of enforcer—are reluctant to use it. They have no equivalent to the Texas Railroad Commission’s recourse to the Texas Rangers.

The rationale for removing Russia from the organization revolves around the ongoing economic sanctions which are making it difficult to meet its quota. As of April, it is thought that Russian oil production dropped 1 mb/d, and projections have suggested that the loss could reach 3 mb/d of sales over the next months. The prospect has already sent prices soaring, with every baby step towards European sanctions on oil purchases adding a few dollars a barrel, if only for a few days.

Thus far, other OPEC+ members have refused to raise production above their quotas for the purpose of offsetting the lost Russian oil supplies, partly because the losses are likely to be temporary as that nation’s oil producers find new customers, and partly out of concern that they might want assistance from Russia during future periods of market weakness.

How important is Russia to OPEC+? Well, in early 2020, Russia contributed 2.5 mb/d of reduction to the group’s market stabilization effort, an amount only exceeded by Saudi Arabia. With Azerbaijan and Kazakhstan, which were no doubt heavily influenced by Russian participation, they made up 1/3 of the reduction. In hindsight, the quotas proved too severe, sending the Brent price up to $100 before the invasion started. Still, it is clear that Russia was, if not the linchpin, a major bulwark of the group’s efforts.

Needless to say, another demand downturn on the order of the covid pandemic appears very unlikely in the next decade, but Russia and its predecessor Soviet Union have often assisted OPEC’s stabilization efforts, albeit with varying degrees of compliance. Still, considering the Russian supply reduction in December 2016, the last pre-pandemic quota agreement, was only 300 tb/d, that is an amount that could easily be made up by the Middle East producers.

However, contagion is not just for viruses. In the pandemic OPEC+ agreement, more than 1 mb/d of reduction came from other non-OPEC members and most of that would probably not have been undertaken without Russian participation. Looking at 2016 again, non-OPEC members besides Russia only offered 260 tb/d of reductions, a relatively minor amount but at least psychological supportive of OPEC’s efforts.

And historically, even OPEC producers have taken their cues from other members’ compliance as in the late 1990s, when Venezuelan production was far above quota and they initially suffered no penalty. In response, nearly all the other members let their production creep up above quota, as the figure below shows. The trend was clearly alarming to the Saudis, who insisted that quotas be raised to allow them to match others’ production policies without violating their own quota. (In this case, Caesar’s wife was promiscuous, but Caesar chose to be above suspicion.)

The issue for OPEC+ members becomes one of whether or not they can keep Russia happy enough to participate in future market stabilization efforts, which are likely to be needed when the war ends and especially if Iran and/or Venezuela escape the effects of sanctions. Simply removing Russia from the group now, however politely done, will make future cooperation much more difficult to obtain, creating more price volatility and increasing the frequency and severity of price wars.

One possible workaround would be to set OPEC+ quotas high enough that other members could raise production to offset the loss of Russian supply, while keeping the duration of the agreement short, no more than three months, so that a return of Russia supply would see the groups’ quota levels reduced to offset. This would be the inverse of the 1998 agreement, where the groups’ quota was increased even though most members were producing flat out already, but a Saudi increase could be accommodated. Set the group quota equal to expected demand, plus the amount of production below quota by Angola, Nigeria, and others, as well as the anticipated lower Russian oil supply. Russian might not be happy with this, preferring wartime price premiums for its often-discounted oil sales, but it could prove an acceptable compromise.

OPEC+ might be worried that Russian supply will recover faster than expected or that a recession would cut world demand, leaving their quotas so high that global inventories will start rebuilding. But given how low they are currently, several months of even 2 mb/d inventory build will not see prices return below $60, where they were before the pandemic began. And the group has shown that they can act promptly when the situation warrants, so the risk of instigating a new price collapse seems relatively low. Which is not to say that OPEC+ members would agree with that assessment, and, as always, it is easier to do nothing.