The Fuse

Despite OPEC’s Reassurances, Market Uncertainty to Persist With Output Cut Extension

by Matt Piotrowski | November 30, 2017

OPEC and its non-OPEC allies agreed on Thursday to extend their production cuts throughout all of 2018. The so-called Vienna Group will continue to curb output by 1.8 million barrels per day (mbd), approximately 2 percent of global supply, in an effort to reduce OECD inventories and increase prices.

“If something is working, you don’t let it go,” Saudi Arabia’s Energy Minister Khalid al-Falih said Thursday.

The extension of the deal reflects OPEC’s continued resolve to intervene in global oil markets. Market participants expressed initial skepticism about how effective OPEC’s actions would be. But the cartel’s determination to increase prices and its ability to coordinate with other producers such as Russia have successfully reduced OECD inventories and pushed international benchmark Brent above $60 per barrel. The price reaction to the deal’s extension was relatively muted on Thursday because market participants had mostly expected an extension through the end of next year.

Ministers are clear that the goal in extending the deal is to further reduce inventories in the OECD, a development that could potentially lead to further price increases.

Falih claimed Thursday that without the deal, oil markets would be experiencing “extreme volatility and greater uncertainty.” But the opposite is in fact true. Even though The Vienna Group can claim success so far, it is contributing to greater oil market uncertainty and instability. Ministers are clear that the goal in extending the deal is to further reduce inventories by at least 150 million barrels in the OECD, a development that could potentially lead to further price increases. Besides lower inventories, oil markets are also contending with greater geopolitical risk (see Venezuela) and continued strong demand growth, a combination that skews price risks to the upside.

Complications with Russia, Nigeria, and Libya

Even though Russia agreed to an extension, it has expressed doubts about the unintended consequences of the deal. The country is particularly concerned that inventories might have declined too quickly and higher prices will stimulate shale production. Russia is a critical player in this agreement, given that it produces more than 11 percent of the world’s crude and it is crucial in increasing the cooperation between OPEC and non-OPEC oil producing states. Russia cut output by 294,000 barrels per day (b/d) in October, but its compliance has been at only 80 percent year-to-date.

At Thursday’s meeting, OPEC also dealt with uncertainty surrounding Nigeria and Libya, both of whom had not been subject to quota because of domestic instability. The two volatile countries will now be included in the deal for the first time and agreed to cap production at 2017 levels. However, given their upside potential for production and the need for revenue, they may not stick to their targets.

Still no exit strategy

Most importantly, the Vienna Group has still not articulated an exit strategy from the agreement, contributing to the uncertain outlook. Once producers reach their goals and decide to wind down the deal, a flood of supply could hit the market at once and drive down prices. Such a scenario would once again create investment uncertainty for the global oil industry as it deals with a fragile recovery in prices and large capital expenditure cuts. The agreement will be reassessed at the next meeting in June based on market fundamentals. At the press conference after the meeting, Falih said that it is “too premature to design an exit strategy” because the group still wants to reduce inventories significantly and ensure that a glut does not return. He claimed that the group would eventually prepare a plan to gradually end the deal, but producers are committed to “rebalancing” for the long term.

Most importantly, the Vienna Group has still not articulated an exit strategy from the agreement, contributing to the uncertain outlook.

There is also the question of compliance eroding throughout 2018, particularly since prices are higher than year-ago levels, giving producers a greater incentive to cheat. OPEC has touted high compliance, but a further look shows that the data is mixed. A number of countries, such as Iraq and the UAE, are producing above their targets, while others are shouldering more of the burden of the cuts. The Saudis, for instance, have had compliance of 121 percent for the first 10 months of this year. This is a reflection of how determined the Kingdom is to construct an effective production deal. Venezuela’s production has fallen sharper than its agreed cut, but the rapid decline is the result of economic instability and political upheaval rather than calculated supply cutbacks.

Saudi Arabia’s Falih and Russia’s Energy Minister Alexander Novak will now co-chair the Joint Ministerial Monitoring Committee (JMMC) to oversee compliance. Having Russia and Saudi Arabia in this role further highlights the growing collaboration between the world’s two largest crude producers. Falih said they are “committed to make sure everyone contributes and contributes equally.”

United front from the Vienna Group

Even though divisions continue, producers put on a united front on Thursday. Falih downplayed any differences with Russia and went out of his way to highlight his country’s increased collaboration and common goals with Russia. The number of countries in the Vienna Group agreement is remarkable: The 24 producers pumped more than 51 mbd last month and make up approximately 55 percent of global production capacity. Ministers confirmed they want to become even bigger. In fact, six countries attending the meeting as observers said they endorsed the agreement, widening the number to 30 producers that are in favor of the deal.

The fact that the market could move significantly in either direction as a result of OPEC’s actions reflects the greater uncertainty the group has brought to oil markets.

A clumsy exit strategy, producers cheating on their quotas, or a rapid response from U.S. shale producers could undermine the effectiveness of the deal. Just before OPEC announced prolonging the deal, the EIA reported that U.S. crude production reached 9.48 mbd in September, up by almost 300,000 b/d versus the previous month. Total U.S. output is closing in on the 9.6 mbd hit in April 2015, the highest level since the 1970s. Falih downplayed the potential for shale to challenge OPEC’s actions. He said shale is a “welcome” contributor to global supply to help meet incremental demand and offset declines at existing fields. He said there was a lot of “fear-mongering” about shale in 2017, but “growth is quite moderate.”

Conversely, the potential for higher prices is also a stark possibility. The fact that the market could move significantly in either direction as a result of OPEC’s actions reflects the greater uncertainty the group has brought to oil markets. Price direction is uncertain, and OPEC’s production agreement, its attempts to impact sentiment through verbal intervention, rising geopolitical instability, speculative activity, and stronger global demand are all setting the stage for more market turbulence.

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