The Fuse

Death by a Thousand Cuts

by Leslie Hayward | May 09, 2017

OPEC’s next ministerial meeting is fast approaching, and with it the deadline for the group and other collaborating oil producers to determine if they will extend production cuts for another six months. High compliance has buoyed oil prices since the previous meeting, and the question at this point is less matter of “if” OPEC-plus will maintain cuts through the second half of the year and more the extent and duration of the cuts. Concurrent statements from Saudi and Russian officials in the last few days are hinting that the deal will reach into 2018. “Based on consultations that I’ve had with participating members, I am confident the agreement will be extended into the second half of the year and possibly beyond,” Khalid al-Falih said on Monday. He was backed up by Russian Energy Minister Alexander Novak, who said that extending the cuts would help speed up a return to a healthier market.

Markets are shrugging off OPEC headlines, with prices weakening and hedge funds liquidating long positions.

Unfortunately for them, markets are shrugging off the headlines, with prices dropping on Monday and hedge funds liquidating their long positions. John Kemp of Reuters reports that hedge fund managers are now at the smallest net long position in crude futures and options since OPEC announced its deal on November 30. Famed oil price bull Pierre Andurand liquidated his oil-focused hedge fund’s last long positions in crude last week. A bad sign for the cartel. Just weeks ago, Secretary-General Mohammad Barkindo bragged that the group’s announcement of its cut boosted speculative length by more than 84 percent from late November to mid-February. OPEC knows it needs speculators for its gambit to work, but Wall Street seems to be done cooperating.

OPEC knows it needs speculators for its gambit to work, but Wall Street seems to be done cooperating.

After 2016’s long year of rhetoric, 2017’s “cut” (which, as we know, effectively just reversed 2016’s collective production increase) pushed WTI prices to recent highs just shy of $55 per barrel, but crude prices have dropped 13 percent in recent weeks and are currently below $46. OPEC never formally disclosed its goals for the cut/freeze, but it’s understood that producers want to keep prices in the $50s  or higher, and move global inventories back into the five-year range.

Right now, OPEC producers are failing at both metrics. OECD inventories have continued year-over-year builds. Prices could rebound following the announcement of fresh cuts, but it’s also likely that an extension of the deal is already priced into the market, and the fact that hedge funds and other speculative money responded to this week’s announcements with ambivalence suggests that OPEC will have to deepen rather than simply extend. There are also the wild cards of Libya, Nigeria and Iraq, who can undermine the deal with unexpected production upswings almost overnight. On top of that, there’s the resurgence of U.S. shale, which has pushed U.S. production back up to 8.9 million barrels per day and slated to continue increasing. As of last Friday, the U.S. oil directed rig count is at 703—up 114.3 percent year-over-year and up 122.5 percent since bottoming out at 316 in May 2016.

OPEC may be missing the mark on its stated longer-term goal of stabilizing the market and preventing a catastrophic correction in the form of a massive mismatch between supply and demand.

Short-term price relief aside, OPEC may also be missing the mark on its stated longer-term goal of stabilizing the market and preventing a catastrophic correction in the form of a massive mismatch between supply and demand. Whether it occurs this year or next, as soon as OPEC’s deal is lifted, more than 2 mbd of supply could come online which will almost certainly cause a dramatic leg down in prices. Meanwhile, extending or deepening the cuts only serves to throw a lifeline to shale and offer hedging opportunities. Under the auspices of stabilizing the market, OPEC is just delaying the necessary correction.

Can OPEC return to its previous strategy of increasing production to squeeze out shale producers? Technically, yes. But there’s no appetite among the group for a price war. Thus, OPEC and its allies seem stuck with a temporary fix that seems sure to inflict greater long-term pain.

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