The Fuse

Expect OPEC to Game Expectations

by Leslie Hayward and Matt Piotrowski | May 22, 2017

Last week, producer heavyweights Saudi Arabia and Russia, which make up more than 20 percent of global crude supply, touted that they have already determined to extend the OPEC/non-OPEC production cut agreement by another 9 months until March of next year. Saudi Energy Minister Khalid al-Falih says the Kingdom and its partners will “do whatever it takes” to bring inventories back into the 5-year range and boost prices. Other producers including Kuwait and Qatar voiced support for the 9-month extension, while Oman and Iraq favor 6 months. Falih on Monday jetted to Iraq, presumably to build consensus around Saudi’s preferred strategy to stay the course through March of next year. It appears he’s had initial success as reports say Iraq is on board for an extension for another nine months.

This week’s consensus is that the 9 month extension is as good as done—but OPEC and its allies know that they need to do more than follow through on last week’s news to support prices in their preferred range above $50 per barrel.

Every OPEC week seems to begin with a foregone conclusion, and in the days before the meeting new rumors will emerge, or there’s a last-minute plot twist. This week’s consensus is that the 9-month extension is as good as done—but OPEC and its allies know that they need to do more than follow through on last week’s news to support prices in their preferred range above $50 per barrel for the long term. If they can pull it together, possibilities include the addition of new countries, a longer extension of the deal, a deepening of the cut, or a change in the compliance conditions for Iran, among others.

The details of Thursday’s outcome aside, more and more market watchers are making the case that OPEC should just leave well enough alone and let the free market set the price. While trying to influence sentiment and fundamentals, on nearly a daily basis, OPEC has already destabilized the market and guarantees more uncertainty ahead. Furthermore, the cartel does not appear to have an exit strategy.

In the near to medium term, success for the cartel will hinge on whether speculators remain bought-in on OPEC’s narrative and the strength of shale’s continued rebound. Longer term, demand is the make-or-break factor.

OPEC is very concerned about investor fatigue. Low compliance among producer states or a weak deal may cause speculators to liquidate long positions or move to the short side, as we’ve seen in recent weeks. “We are hitting back at the shorts,” one OPEC official told reporters, one of many indicators that the cartel is boosting efforts to combat speculative selling. In a pivot from a previously antagonistic relationship where OPEC blamed speculative traders for contributing to high and volatile prices, OPEC has been meeting with hedge funds and other money managers within the past year to better understand their strategies, build consensus that the cartel’s efforts are credible, and more effectively leverage verbal intervention to manage sentiment. If we see OPEC come through with a stronger deal than the one announced last week, it could be a sign that they are perfecting this art.

OPEC has been meeting with hedge funds and other money managers within the past year to better understand their strategies, build consensus that the cartel’s efforts are credible, and more effectively leverage verbal intervention to manage sentiment.

In addition to managing investors, shale’s resurgence is OPEC’s biggest concern, as it could puncture prices and induce even more instability. “Like monsters in a horror movie, these [shale] businesses have proved exceptionally hard to kill off,” wrote Ed Crooks in the FT, summarizing how resilient the U.S. oil industry has been.

On the flip side of the risk that a flood of shale supply could undercut the price, there’s also the possibility that OPEC will be too successful and tip fundamentals into a deficit, reducing the much-needed buffer provided by high inventories as long-term upstream investment remains sluggish. The International Energy Agency (IEA) warned of a tighter market last week, a counterargument to the pervailing narrative that shale will ultimately crush OPEC. While the IEA does in fact highlight the extraordinary performance of shale since bottoming out last year, the agency also notes that the market rebalance is “accelerating.” Total OECD inventores fell by one million barrels per day (mbd) in March. They are expected to decline by 700,000 b/d in the second quarter, the agency says, with even sharper drops during the second half of the year.

“As long as there is uncertainty in the market, OPEC will play a role,” said Jeff Quigley of Stratas Advisors. “Volatility may not be good for members from a revenue perspective, but it’s good from an organizational perspective. A stable and predictable market would remove their mandate and make them irrelevant.”

Although overall volatility has lessened in recent months and the market has remained rangebound near $50, prices do see sharp fluctuations on a day-to-day basis. The more OPEC talks up the market or takes action to boost prices, the more traders react. The volatility draws more speculative activity, prompting the market to hang onto every word from ministers and other OPEC sources, reinforcing the group’s outsized impact. “As long as traders continue making bets on OPEC, then OPEC will continue to keep talking up the market and trying to influence the price,” said Quigley.

Traders and shale aside, the ultimate threat for the organization may lie elsewhere. “The biggest existential risk to OPEC is not shale, it’s demand,” said Quigley. “A rise in electric vehicles and energy efficiency improving faster than expected are the dangers. But peak demand expectations may be overblown now and we may have another price spike before we get there. That benefits OPEC.”

The global oil market does not have a consistent narrative at the moment, and OPEC will keep one from emerging as long as it steps in (usually when prices drop) and takes action, whether through rhetoric or production adjustments.

The global oil market does not have a consistent narrative at the moment, and OPEC will keep one from emerging as long as it steps in (usually when prices drop) and takes action, whether through rhetoric or production adjustments. While OPEC induces uncertainty and volatility in the short run, the cartel’s actions and strategy prompt more questions longer term. Its production cut has boosted shale, but the growth in U.S. tight oil has brought about just a short-term fix. Shale has provided a buffer against OPEC cuts and geopolitical outages, but it will likely be limited in meeting long-term market needs. Investment in bigger deepwater projects and higher-cost conventional fields have been choked off, setting the stage for price spikes or other volatility at the end of this decade or in the early 2020s. OPEC will be finding ways to play this to their advantage—whatever it takes.

 

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