The Fuse

Analyst: OPEC’s Cut ‘Unbalanced’ the Market

by Matt Piotrowski | March 31, 2017

OPEC did not need to cut production to rebalance the market, according to one prominent oil market analyst. In fact, the output cut, agreed late last year to accelerate a tightening in fundamentals and boost producer revenues, was mostly self-defeating and caused fundamentals to become “unbalanced.”

The global oil market was already balancing by itself late last year, but by cutting, OPEC has had to contend with unintended consequence of its actions.

Speaking at the Center for Strategic and International Studies (CSIS) on Thursday, Ed Morse, Global Head of Commodities Research for Citi, argued that the global oil market was already balancing by itself late last year, and by cutting, OPEC has had to contend with unintended consequence of its actions.

“Problem? There was no problem,” Morse said, pointing out that petroleum inventories were already drawing during the fourth quarter of last year.

A large stock build in the first quarter, rampant producer hedging, and large amount of investor inflows in the futures market have created an “unbalancing of the market,” the opposite of OPEC’s stated goal.

Heavy buying in the physical market during the fourth quarter, ahead of the output cut at the beginning of 2017, occurred because buyers wanted to purchase volumes before fundamentals tightened and prices rose. That, in turn, led to a huge stock build during the first quarter of this year, after barrels reached their destination, making fundamentals sloppier. This trend has been reflected in U.S. crude inventories rising by some 55 million barrels, or 11 percent, since the end of 2016. OPEC’s action led to a short-term run-up in prices, and in turn, better revenues, but it “set the stage for its own unraveling” by boosting inventories.

OPEC’s action led to a short-term run-up in prices, and in turn, better revenues, but it “set the stage for its own unraveling” by boosting inventories.

Morse also noted—in his presentation entitled “OPEC: Hoisted by Its Own Petard?”—that another problem OPEC created for itself was the massive wave of hedging among U.S. shale producers, guaranteeing growth in U.S. output this year. Morse estimated that some 70 percent of projected growth in shale for 2017 is already hedged. When prices along the NYMEX futures curve rose as OPEC agreed on its production cut, players in the U.S., particularly the prolific Permian in West Texas, had incentive to sell their production forward through hedges. Locking in prices along the curve has provided guaranteed financial support for producers in the U.S., a key factor in the industry’s revitalization since the market bottomed out under $30 in February 2016.

The record amount of investor flows into crude futures and options has also brought about difficulties for OPEC. While the buying among inventors created “the appearance” that the market had tightened, prices were actually “in a froth,” setting the stage for a correction. The high level of net length—the number of non-commercial players betting on higher prices—reached levels that couldn’t be sustained. Against that backdrop, prices fell sharply earlier in March as some investors liquidated.

NYMEX front-month futures have rebounded to above $50 per barrel, but their direction appear uncertain. The trends that OPEC set in motion—a rebound in shale, the rapid stock rise, and bullish bets by investors—will be key issues to watch to see whether OPEC’s action can hold up the market, or whether it will continue to “unravel.”

Wood Mackenzie said this week that the average costs for global deepwater projects have fallen by more than 20 percent since 2014.

Besides these shorter-term issues, OPEC must also contend with competition from deepwater, which is seeing cost declines. Consultancy Wood Mackenzie said this week that the average costs for global deepwater projects have fallen by more than 20 percent since 2014. WoodMac, when assuming a 15 percent internal rate of return, estimates that some 5 billion barrels of deepwater reserves would breakeven at $50 or lower. A further 20 percent drop has the potential to bring another 15 billion barrels into play. This makes deepwater look attractive when compared to U.S. shale. “The deepwater value proposition will strengthen as tight oil cost inflation returns,” WoodMac says. “A 20 percent rise in tight oil costs would mean that the two resource themes effectively have the same opportunity set measured by volume in the money at US$60/boe.”

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