Why we should be cautious of Saudi Arabia and Russia's oil deal

The oil markets have given a lukewarm response to the tentative deal between Saudi Arabia and Russia to freeze their output at its January levels. Critics are wary too, as it was unlikely that either country would have increased production much more anyway. For the deal to have any teeth, Saudi Arabia in particular needs to be willing to cut output, not least to offset the increased supply still to come from Iran.

To recap, the meeting today between Saudi Arabia, Russia, Venezuela and Qatar has apparently concluded with an agreement that these four countries will freeze their output at its January levels, provided other major producers follow suit.

At face value this is a potentially important development. Estimates vary, but Russia currently produces around 11m barrels per day (bpd) and Saudi Arabia more than 10m, together contributing roughly 22% of global supply. Venezuela and Qatar between them provide another 3m bpd, meaning that the four countries already signed up to the deal account for around a quarter of world production.

However, there are at least three good reasons to be cautious. Firstly, the agreement is dependent on others joining in. Most of the other Opec members will probably happily sign up to this agreement, given that they do not have the capacity to increase output even if they wanted to, and so would be sacrificing nothing. However, Iran is planning to increase output by at least 500,000 bpd this year following the lifting of Western sanctions.

Iran has already indicated it is unwilling to freeze its output until it reaches pre-sanctions levels, which implies an increase of at least 1m bpd still to come. What is more, Iraq is also planning further ambitious increases to its production over the next few years, which it will be loath to give up on.

Secondly, the success of the deal will depend on Russia playing its full part. The track record here is not good – Moscow reportedly reneged on a similar deal in 2001. Indeed, it is only a few weeks since speculation of coordinated output cuts unravelled.

Nor is there any indication that other major non-Opec producers are willing to participate. Brazil, Canada, Mexico and Norway, for example, together produce around 10m bpd, and there is no suggestion they are interested in being involved. Above all, if oil prices do rebound, the US shale industry will presumably bounce back too.

Finally, even if total Opec output can be capped at its January levels (implying any increase from Iran, or other members such as Iraq, is offset by cuts elsewhere) this would still be exceptionally high. Indeed, the oil cartel's production in January was a record high. The same point applies to current production in Russia, where output reached a post-Soviet high in January. In other words, this deal would simply maintain the excess supply that is now in place. This might be better than a further increase, but it is not the output cuts that some in the markets had been hoping for.

The upshot is that the deal leaves plenty of room for disappointment. Nonetheless, oil prices have at least been relatively stable since late January, rather than continuing its downward slide. We continue to expect prices to recover over the remainder of the year (our end-2016 forecasts for both Brent and WTI are $45 per barrel). However, this is based on stronger global demand and reductions in non-Opec supply in response to the previous sharp falls in prices, rather than the prospects of successful coordination between the cartel and Russia.

Thomas Pugh is a Commodities Economist at Capital Economics