The decision by the producer group to not “freeze” production is a bit like Russian General Kutuzov not surrendering Moscow to Napoleon in 1812. Lower prices in the short‐term will encourage lower production in many countries including the U.S. Allowing the fundamentals to play out may actually reduce the surplus faster.

Napoleon’s Retreat from Moscow

Freezing production at end-January production levels, but with Iran and Libya on the sidelines, was going to have little to no impact on the fundamentals. All of the 18 producing countries, except perhaps Saudi Arabia (and of course Iran) are producing and selling all that they can. A production freeze by this group, therefore, would not have markedly reduced the surplus, but it would have temporarily raised crude oil prices. As prices rose in recent weeks, oddly anticipating a market-lifting agreement in Doha, Brent and even WTI came close to the price level that we believe helps U.S. shale output. Prices in the mid $40s (WTI got to $41) are akin to throwing shale producers a life preserver in heavy seas. It is not clear that U.S. producers could expand production at $45 WTI, but certainly a return to the mid $40s would temper the production decline in the U.S.

If oil producers truly want higher prices, then freezing production at this moment in time would do little to help their cause because it would support prices and marginally help U.S. crude output while doing little to eliminate the surplus. This coalition of as many as 18 producers has been impressive in their collaboration, but short-sighted in their approach. They are struggling financially with the drop in oil prices, but their interests are not served by providing a marginal benefit to U.S. producers who are likewise struggling, but who have the most decentralized, financially creative industry in the world. So, from the perspective of the 18 countries in Doha, the “no deal” decision is like General Kutuzov’s unwillingness to surrender Moscow to Napoleon in 1812. They are letting the fundamentals play out, which will encourage the 2016 decline in U.S. production (and elsewhere). Napoleon’s army barely survived the march home in the severe Russian winter. The decimation of Napoleon’s army has been immortalized in the famous graphic presented below. The beige line shows the size of napoleon’s army as it marched to Russia (422,000 strong) and the black line shows the size of the army as it marched home (10,000 stragglers), losing thousands in the bitter cold. Regardless of the geopolitical reasoning, the Doha result will let the cold winter of low prices propel the incipient decline in crude oil supply.

The seasonal increase in crude oil demand over the next couple of months will lift prices from the post-meeting floor we are likely to hit in coming days. If prices rise too fast, then the gradual drawdown of the surplus, timed to start in the second half of 2016, according to the ESAI Energy Global Oil Balance, could slow down. A decision to freeze production would have supported oil prices more quickly, whether warranted or not, and slowed down the reduction in the surplus by even more.
Source: ESAI Energy