The Fuse

Market Uncertainty Ahead as OPEC Looks to Extend Production Cut Through 2018

by Matt Piotrowski | November 21, 2017

All eyes in the oil market will be on OPEC next week as members gather in Vienna for the cartel’s meeting. Market participants expect OPEC, along with their non-OPEC allies, to follow through with an extension of production cuts through the end of 2018. The Iranian oil minister on Monday confirmed that most OPEC countries were in favor of extending the agreement until the end of next year. Although it is widely believed that the cartel and non-OPEC participants will continue with their deal, there is, of course, the possibility of a surprise and the agreement breaks down. However, the failure to continue the production cut, which curtails about 2 percent of global supply, would likely precipitate a significant price decrease.

Circumstances surrounding the upcoming meeting are sharply different than those of the past few years. From November 2014 through the middle of 2016, OPEC was contending with rising inventories, weakening prices, and commentary that the producer group was incapable of managing the market in its favor. This time around, expectations are different. The cartel’s production cut has successfully increased prices to above $60 per barrel, reduced the inventory overhang in the OECD, and revamped its image. The market now expects OPEC to continue to “manage” fundamentals and provide a floor under prices.

While there are a number of factors contributing to price uncertainty, OPEC’s action is at the center of it.

Even though oil prices have reached the reported OPEC target of $60 per barrel, the oil market is far from stable. While there are a number of factors contributing to price uncertainty, OPEC’s action is at the center of it. Market fundamentals have tightened throughout 2017, a reflection of the impact of OPEC’s cut. And some of the same questions that have dogged the cartel since it agreed on the cut a year ago are still relevant.

Response of shale, non-OPEC supply

OPEC has long since worried that if it cut production to increase prices, the higher price level would simply stimulate a wave of U.S. shale production. This concern still holds. Although U.S. and total OECD commercial inventories have declined this year, higher non-OPEC supply may cause stocks to rise again in 2018. With oil prices above $60, U.S. shale producers hedging production forward, guaranteeing new supply will come online. Net short positions of swaps dealers on the NYMEX have increased to 525 million barrels, a sign U.S. shale producers have been relatively aggressive in hedging.

OPEC has long since worried that if it cut production to increase prices, the higher price level would simply stimulate a wave of U.S. shale production. This concern still holds.

The U.S. Energy Information Administration (EIA) forecasts U.S. crude production to rise by 720,000 barrels per day (b/d) next year, with total non-OPEC supply to increase by 1.5 million barrels per day (mbd). If the EIA is correct in its analysis of 2018, new supply coming online would counteract a large portion of the 1.8 mbd OPEC/non-OPEC cut. Such a scenario would likely lead to weaker prices. However, if non-OPEC supply growth does not meet expectations and OPEC continues with high compliance, the market could tighten further. Against this backdrop, oil prices could rally to even higher levels than we see today.

Speculators’ bets

Speculators in the crude oil futures markets have amassed record level bets on higher prices. This trend has supported OPEC and its goals. The producer group has managed expectations and used verbal intervention in order manipulate sentiment among investors, adding to a stronger market.

The cartel is well aware, through its meetings with hedge funds this year, that a failure to extend the production cut will likely lead to speculative selling and sharply lower prices. But its attempt to manipulate sentiment will go beyond this upcoming meeting. To keep prices elevated, its members will have to continue to comply with the agreement and give statements to the press that they remain committed to their pledges. Furthermore, they will also need for non-OPEC supply growth to be moderate in 2018 and for demand to continue to grow at a healthy pace. If fundamentals loosen for any reason, speculative selling may lead to a downward correction.

Instability in OPEC countries

A number of OPEC countries are now dealing with political risks. Venezuela is the most concerning at this point with production falling to a 30-year low amid deteriorating economic conditions. Output could fall by another 700,000-800,000 b/d, further tightening the market. Nigeria’s production has struggled to recover as a result of militant attacks. Continued fighting among factions in Libya has kept output below its potential. At the same time, the Middle East is seeing greater volatility. Potential regime instability in Saudi Arabia, the heightened Iranian threat to the Saudis, the widening war in Yemen, and extremely unstable situations in Iraq, Syria, and Lebanon are causing many to ask if the region is headed for a major catastrophe.

The number of barrels at risk of outages are increasing, and a geopolitical risk premium has returned to the market.

Despite their ongoing problems, Nigeria and Libya could increase their production since neither is subject to quota. Still, the number of barrels at risk of outages are increasing, and a geopolitical risk premium has returned to the market, thanks to rising threats in oil-producing countries.

Still no exit strategy

“We don’t intend to exit so there is no exit strategy,” Saudi Energy Minister Khalid Al-Falih said after the OPEC meeting in May. “The fact that we don’t yet have a strategy for later 2018 does not mean we won’t have a strategy; it just means that we will evaluate market conditions at that time.”

The group still has not put together a credible exit strategy.

Since the meeting earlier this year, the group still has not put together a credible exit strategy. Market participants have warned that OPEC is creating uncertainty for itself and the oil market in general by not articulating a policy for exiting the agreement smoothly. Unless OPEC puts forth an exit strategy, traders will assume that a flood of supply will come when the deal expires.

Wide range of scenarios

The range of possible outcomes ahead in the oil market—from a dramatic selloff from surging non-OPEC supply to a sharp price rally from unplanned supply outages—is inconsistent with the stability that OPEC says it wants to achieve. The cartel will attempt to manage perceptions in both the physical and financial markets—but given its track record, it will not likely produce stability and certainty, but instead ambiguity and volatility.

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