The Fuse

Measuring the OPEC Cuts

by Matt Piotrowski | January 13, 2017

“There’s a lot to consider when assessing OPEC cuts: New oil field developments (for example, Iraq and Iran joint oilfields), who is and is not sticking to compliance, floating storage, seasonality production fluctuations, special meetings, changes in exports, and shifts in geopolitics and relationships among members.”

Traders and analysts have held, from the very beginning of talk about an OPEC cut or freeze, a large amount of skepticism surrounding the cartel actually following through on any pledge. This suspicion comes with good reason given members’ history of cheating and the distrust within the organization itself. Furthermore, the last two major cuts—in 1998 and 2008—occurred during periods of significant demand erosion, making removing barrels from the market a much simpler decision. Now, however, the agreement is happening amid a supply gut. Demand is growing at a healthy clip, giving more incentive to cheat. Are market watchers underestimating OPEC too much this time around? Now that implementation has begun and the monitoring committee is set to meet next week, it’s worth taking stock of what action has already occurred and what signals to look for in the coming months.

“There’s a lot to consider when assessing OPEC cuts: New oil field developments (for example, Iraq and Iran joint oilfields), who is and is not sticking to compliance, floating storage, seasonality production fluctuations, special meetings, changes in exports, and shifts in geopolitics and relationships among members,” Lisa Ward and Sam Madani at TankerTrackers.com told The Fuse.

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With such a long list, the task of following the cut and its impact will be arduous, though not completely futile. There are already signs that OPEC is committed to following through with pledges, even if indicators are contradictory and vague at the moment. The oil market has stabilized in the low-to-mid $50s, indicating the group has indeed put a floor under prices for the time being, and there are signs of supply cuts portending tightness.

Saudi Arabia has cut crude sales for February to China and countries in southern Asian countries, and the country’s energy minister, Khalid Al-Falih, said the Saudis have cut back to below 10 million barrels per day (mbd). Other Arab Gulf states such as Kuwait and UAE appear to be following the Kingdom’s lead. Though they are reducing volumes to Asia, they will cut more the U.S. and Europe, in an effort to reduce Atlantic Basin stock levels and support benchmark futures prices. Iraq has said it will cut by 210,000 b/d and claims it has already throttled back by 160,000 b/d, but shipping data says exports will rise in February. “Given that OPEC spends more time discussing production as opposed to actual exports, we feel that the topic is almost entirely neglected but should be placed front and center as exports are what affect the actual global imbalance,” said Ward and Madani of TankerTrackers.com. The Saudis have more than 200 million barrels in land-based storage, allowing them to boost exports—all while keeping output flat—should they want to compete for market share again. Regarding Iran, the country has significantly drawn down floating storage recently, shipping volumes to China, South Korea, Japan, India and some customers in Europe, according to TankerTrackers.com.

A flatter curve

In order for the cuts to stabilize fundamentals, OPEC will want to “normalize” inventory levels by flattening the forward curve or pushing it into backwardation (when prompt prices are higher than future contracts) in order to take away the financial incentive to store crude. This development is key to watch. Even if prices don’t rally, a reshaping of the forward curve is essential strategically for OPEC to manage the market to its benefit and reduce inventory levels. As of now, front-month spreads remain in contango, but contracts from August to December are essentially flat. This means that the market believes fundamentals will be rebalanced in the third quarter.

Even if prices don’t rally, a reshaping of the forward curve is essential strategically for OPEC to manage the market to its benefit and reduce inventory levels.

All this is not to say that the situation will inevitably remain in OPEC’s favor. Shale’s rebound will take some of the bite out of any cuts. The Energy Information Administration (EIA) now says that U.S. production ought to grow by about 100,000 b/d this year, and another 300,000 b/d in 2018. Libya, not tied to any production target as it recovers from civil war, has more than tripled output since its low last year to 708,000 b/d, and could rise more.

Beyond all that, there is also the question of non-OPEC countries’ pledges, crucial to bringing about a successful deal. Bahrain and Oman have said they’ve taken steps to cut output, while Mexico will likely rely on natural declines to fulfill its obligation of 100,000 b/d. The main non-OPEC source—Russia—reportedly cut output by 100,000 b/d during the first week of January, but the reduction could have been the result of harsh winter weather rather than compliance. It’s still too soon to see how credible Russia’s commitment will be. Details won’t emerge until later this quarter. Russian Energy Minister Alexander Novak said Russia will throttle back by 200,000 b/d in the first quarter and reach the cuts of 300,000 b/d after that to reduce output to 10.95 mbd, which is still above the average for the first eight months of last year.

Deal already a success

Even if prices don’t rally much beyond current levels, the cartel has already made its impact with verbal intervention, underpinning the market at the $50 level and tightening the forward curve.

In the coming months, market watchers’ heads will be spinning from the different data points and contradictory reports, along with the amount of volatility spurred by the string of news. The deal may need to hold beyond the six-month pledges for it to fully work, and it’s unclear yet whether Saudi Arabia plans to return to its former role of active market management by continuing to manipulating supply levels to keep fundamentals balanced. Still, it’s important to note that even if prices don’t rally much beyond current levels, the cartel has already made its impact with verbal intervention, underpinning the market at the $50 level and tightening the forward curve.

 

 

 

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