The Fuse

Despite Risks, OPEC Likely to Extend Cuts for 2H 2017

by Matt Piotrowski | March 01, 2017

All signs point in the direction of the cartel continuing to restrain supply during the second half in order to support prices.

There’s been a lot of chatter about whether OPEC will extend its cuts at its next meeting in late May, and all signs point in the direction of the cartel continuing to restrain supply during the second half in order to support prices. Of course, three months is a long time in today’s oil market and much could change, but the growing confidence among hedge funds for higher prices and the expectation of a tighter market during the second half of the year make it more likely than not OPEC will continue to manipulate output by throttling back for the rest of 2017, even if the strategy is fraught with risk.

Hedge funds go way long

While the current relatively strong market is in part the result of tighter fundamentals and OPEC’s persistent verbal intervention over the past year or so, buying among hedge funds and other investors have underpinned prices. As of now, net length among money managers in the petroleum complex on both ICE and NYMEX has reached a record, surpassing 1.12 million contracts, or more than 1.12 billion barrels.

Although the numbers are staggering, the influx is expected to continue on the perception the market will continue to tighten for the rest of 2017. According to Reuters, passive investors, such as those in index funds, are poised to pour an estimated $2 billion in crude futures throughout the next week.

Should OPEC abandon its pledge to restrain output, a massive wave of liquidation would cause a sharp drop in oil prices, a scenario that reinforces the cartel’s motivation to maintain its strategy.

Compliance good so far

Although members will be tempted to cheat as demand rises, OPEC will want to present an appearance of harmony to show strength and that it has the power to manipulate fundamentals and affect prices for its benefit.

One of the thorniest issues inside OPEC has been the issue of compliance. Members cheating on production targets led to, in former Saudi Oil Minister Ali Naimi’s words, “a lack of trust,” prompting Saudi Arabia to keep production elevated for more than two years into the price collapse before pivoting to cutting output in November 2016. Although some members have not fully met their pledges, there has been growing confidence inside the cartel that members can deliver on a majority of promised cuts (see graphic below from Bloomberg).

compliance

Although members will be tempted to cheat as demand rises (and some are reportedly doing so already), OPEC will want to present an appearance of harmony to show strength and that it has the power to manipulate fundamentals and affect prices for its benefit. High compliance, for now at least, can allow members to get rid of the “OPEC is dead” narrative, a common theme from analysts and journalists after the cartel didn’t take action to stem the price collapse.

Stable market in OPEC’s favor?

The oil market has shown remarkable stability recently, with NYMEX WTI trading in the $52-$55 range and ICE Brent a couple of dollars higher. Given the inherently volatile nature of the oil market, it’s not clear how long this situation can last. OPEC has made a big gamble with its production cut. A surge in shale production, combined with OPEC members pumping above their targets and slower-than-expected demand growth, could bring about another leg down. Even the Iranian Oil Minister acknowledged that prices above $55 would be counterproductive. Others may disagree on the desired level, but the see the danger of prices rising too far. Reuters reported, citing unnamed sources inside and outside OPEC, that the Saudis are targeting $60 this year, a level that “will not encourage that big increase in shale.”

The market wouldn’t likely be at this level without OPEC’s rhetoric and action.

Although prices might not be as high as some members want, the current stability works in the group’s favor. The OPEC cut is keeping a downturn at bay. It has underpinned prices by allowing more hedge funds to bet on higher prices and giving the perception that fundamentals will tighten during the second part of the year. The market wouldn’t likely be at this level without OPEC’s rhetoric and action. Hans van Cleef of ABN Amro warns that oil will retreat to the $30s if OPEC doesn’t commit to an extension. In light of that sentiment, OPEC will need to continue curbing production to keep prices elevated for a protracted period, even if it brings about major risks down the road—non-OPEC supply growth may once again overwhelm the market, so much that OPEC will be back in a situation similar to November 2014.

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