The Fuse

All Eyes on OPEC as Global Glut Persists

by Matt Piotrowski | November 17, 2016

Given the dire straits of OPEC countries’ fiscal situations, the cartel may ultimately take action at its meeting on November 30 to lift prices, a move that would hurt consumer countries. But a production cut isn’t a forgone conclusion.

Ever since OPEC decided at its November 2014 meeting to keep the market oversupplied in an effort to rebalance fundamentals by curbing non-OPEC supply and stimulating demand with low prices, the global oil market has been on a wild ride (see graphic below from BMI Research). It’s not going to calm down anytime soon, either, particularly with expectations of a cut at the cartel’s meeting on November 30 shifting at a dizzying pace. Agreeing to cut output is not going to be easy, and the meeting could end in failure because of rancor and distrust among OPEC members. But given the dire straits of the countries’ fiscal situations and questions surrounding the reputation of the group in general, OPEC may ultimately take action to lift prices, a move that would hurt consumer countries.

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“This meeting is somewhat existential in nature,” Andrew Lebow of Commodities Research Group told The Fuse. “The group can’t afford another fiasco.”

At the moment, OPEC basically has three options. First, it could follow through on its pledge at Algiers in late September to curb output to the target of 32.5-33 million barrels per day (mbd) and hope that’s enough to draw down inventories and lift prices. Second, the cartel could say it will take a “wait-and-see” approach and attempt to jawbone the market higher—once again—by explaining to the press, traders, and analysts that fundamentals are improving in its favor. OPEC members’ rhetoric has caused volatility all year, with rumors of a supply freeze or cut pushing up prices at certain times. Third, members could abandon any cooperation as a result of their competing interests and hope that low prices will underpin demand and further knock-off non-OPEC supply, such as shale in the U.S.—developments that could ironically boost the cartel’s power in the longer term.

A cut, the first one since 2008, would be a bullish signal to the market, yet it could also be self-defeating: If members don’t ultimately follow through on the agreement and stocks continue to build, prices would retreat, perhaps sharply.

None of the outcomes should be ruled out, and the possible market reactions to each are seemingly endless. A cut, the first one since 2008, would be a bullish signal, yet it could also be self-defeating: If members don’t ultimately follow through on the agreement and stocks continue to build, prices would retreat, perhaps sharply. Furthermore, OPEC throttling back may not be enough to rebalance fundamentals and push prices to levels that members want and need. U.S. producers are hedging, floating storage has grown, and forecasts call for the market to be in surplus throughout 2017—just like 2015-16. No agreement, meanwhile, would motivate hedge funds and other speculators to further short oil futures—which is betting on lower prices—and sell the market down, likely into the low $30s—a positive for consumers, but another blow to oil producers and long-term supply.

Why a cut is likely

The global supply situation, from a producer’s perspective, has not improved and there are signs it is worsening.

There are two main reasons why OPEC would move ahead with its cut in Vienna at the end of the month, both which are tied to the overall credibility issues the group is facing. For one, the global supply situation, from a producer’s perspective, has not improved and there are signs it is worsening. The U.S. inventory build of 14 million barrels at the end of October, the largest weekly build ever, was eye-opening. The build, along with an increase of 5.3 million barrels last week, confirms that the market in the world’s largest consumer remains oversupplied. At the same time, producers in the shale patch were emboldened when prices traded above $50 per barrel, adding rigs and hedges. Right now, U.S. production has appeared to stabilize at 8.7 mbd, after falling for five straight quarters.

Just as important, floating storage and stockpiles have grown outside the U.S. For instance, in the past month, some of the global stocks being held on tankers have risen by roughly 13 million barrels just in areas in and around Singapore, Malacca, and Iran, according to data from traders at #OOTT (Organization of Oil Trading Tweeters).

Stockpiling is not just happening on the water. China, which imported a massive 8 mbd in September, took advantage of low prices in July to buy crude for storage, while other countries have added to their strategic petroleum reserves (SPRs). Given that there is so much in storage, buyers can hold off, further weakening the market. Against this backdrop, a supply cut from OPEC could be the only way to tighten fundamentals in the short run.

The other reason a cut is likely to occur is the massive fiscal pain the countries are now experiencing. According to a recent report from Wood Mackenzie, all five major oil-producing countries in the Middle East are running budget deficits this year and need higher prices. Kuwait’s breakeven for this year, the lowest among the group, is $57 per barrel, while Saudi Arabia’s, the highest, is $92 per barrel, about double current levels. “It will be 2020 before all are back in the black or running a fiscal surplus, based on our expectation for the oil price to return to $85/bbl (real) in 2020,” said Woodmac.

Another sell-off in the oil market would be detrimental to member countries, providing further motivation for a deal. “With prices in the current range, more of the smaller oil companies would need to declare bankruptcy, there’d be more layoffs and more strikes,” Lisa Ward, an independent trader and co-founder of #OOTT, told The Fuse. “The Saudis, who are already struggling due to the low oil prices with their breakeven price per barrel of oil at approximately $80, may need further support from the IMF and encourage them to speed up the Aramco IPO. Other countries are also suffering, just look at Venezuela.”

Why a cut is unlikely

Despite the fact that all producers are all undergoing economic pain because of low prices, acrimony among members surely persists, threatening any agreement.

A number of factors, meanwhile, could keep an agreement from happening. For one, the group can’t even agree on what each member is producing. OPEC producers have to figure out what baseline output numbers to use before they can agree on how much to cut. This will not be easy given the large gap between numbers from the producers themselves and data from secondary sources. In the latest OPEC Monthly Oil Market Report, it reported that the cartel’s production is 33.6 mbd, but based on direct communication from each, output is 1 mbd higher. Failure to agree on simply what current output levels are may be an impediment members can’t get past.

Political factors could also derail a deal. Saudi-Iran tension, which undermined talks to freeze output in Doha in April, is one threat. Libya, Iran, and Nigeria will all reportedly have exemptions from a cut because of having to deal with outages, but will they be satisfied with having to freeze production? Iraq says it’s producing more than 200,000 b/d above secondary source levels, meaning that arguments over the country’s baseline production numbers and how much it should cut could be the most contentious part of the meeting. Despite the fact that all producers are all undergoing economic pain because of low prices, acrimony among members surely persists, threatening any agreement.

OPEC wants out of this range

“OPEC clearly wants to get prices out of the current range,” said Lebow, who added that even if OPEC agrees to a deal, it will have to spin the outcome for it to appear as though it’s supportive for the market. Relying on a cut to support prices, OPEC is taking a big risk. After using bullish rhetoric all year to prop up prices, it has positioned itself in a spot where it needs to act, or the market could collapse and all members’ post-meeting talk will likely fall on deaf ears. The markets, and all consumers, are in for a bumpy ride, no matter what happens in Vienna.

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