The Fuse

OPEC Announces First Cut Since 2008: Implications for Prices, Credibility, and U.S. Shale

by Leslie Hayward and Matt Piotrowski | September 28, 2016

Following what appeared to be a clear consensus that no deal would emerge from this week’s conversations in Algeria, the Organization of the Oil Exporting Countries (OPEC) announced today that the group will cut oil output levels to 32.5-33.0 million barrels per day (mbd), with details to be finalized at the next official meeting at the end of November. That production number is as much as 1 mbd below the group’s current total output levels of 33.5 mbd, and represents the closest thing to an official production cut that the group has announced in almost 8 years.

Although OPEC was able to give a number today on its collective production, the lack of details announced alongside the new production cap reveals that many internal fissures persist. Those fissures didn’t stop oil prices from rallying nearly 6 percent.

The decision, which followed several days of pre-meeting negotiations and a nearly five hour closed-door session alongside the International Energy Forum in Algiers, was greeted with some skepticism by industry watchers. OPEC failed to even set a total production target at the group’s last two official meetings, and the gathering in Doha in April resulted in a last-minute collapse of talks, which have all served to undermine the group’s credibility. Although OPEC was able to give a number today on its collective production, the lack of details announced alongside the new production cap reveals that many internal fissures persist. Those fissures didn’t stop oil prices from rallying nearly 6 percent.

On Tuesday, before the closed door session, Iran reportedly rejected an offer from Saudi Arabia to keep its oil output below pre-sanctions levels in exchange for a supply reduction from Saudi, which brought about headlines this morning that no deal was expected today. “The gap (in views) between OPEC countries is narrowing. I don’t expect that an agreement will come out of the consultations tomorrow,” Saudi Energy Minister Khalid al-Falih said yesterday.

That same tension between Saudi Arabia and Iran scuppered an agreement in Doha. The Iranian oil minister was not present at the Doha talks, but the agreement—spearheaded by then Saudi Oil Minister Ali al-Naimi—allowed room for Iran to continue to increase while other members froze. The deal was cancelled at the last minute based on orders from Riyadh.

Although Saudi Arabia and Iran remain adversaries, today signals a shift, at least on some level, in both countries’ willingness to cooperate—likely out of fears of another leg down in oil prices if an agreement to constrain output was not put in place. Recent data shows that most OPEC members, plus Russia, are pumping at record volumes.

Recent data shows that most OPEC members, plus Russia, are pumping at record volumes.

“What’s overlooked is that Oil Minister Bijan Zanganeh said today for the first time that Iran will accept the use of more reliable secondary source estimates for output,” said Matthew M. Reed, Vice President of Foreign Reports, a D.C. based consultancy specializing in energy geopolitics in the Middle East. “That means baselines can be agreed to. It also gives Iran wiggle room because they typically overstate their numbers. Thus, Iran could claim to reach its target output level while falling short in reality, but it won’t matter because Iran’s claims are not a part of the equation. That’s the first concession they’ve made since sanctions were lifted.”

Now, all eyes turn to the November 30th OPEC meeting in Vienna, where the group must prove that today’s announcement was more than bluster to prop up prices. OPEC has its work cut out for it. At the next meeting, the group promises to announce the commencement date and duration of the 32.5-33 mbd production target, in addition to individual country quotas—which OPEC last implemented in 2008 during the production cut. In addition to the possibility that Saudi Arabia and Iran’s tensions will interfere, there are other threats to any potential agreement. These include ongoing production outages in countries including Nigeria and Libya, as well as Iran’s ongoing return from sanctions. Saudi Energy Minister Khalid Al-Falih has stated that certain accommodations would be made for countries whose production has been disrupted by internal violence, but both Nigeria and Libya are far from their peak production levels. Nigeria is experiencing some .5 mbd of disruption compared to 2015 levels. Libya is more complicated, with production having remained below .5 mbd since 2013, well under previous highs of 1.6 mbd. One of the biggest questions coming out of today’s announcement is how the significant upside offered by Nigeria, Libya, and Iran will be factored into the 32.5-33 mbd number.

One of the biggest questions is how the significant upside offered by Nigeria, Libya, and Iran will be factored into the 32.5-33 mbd number.

In addition to this challenge, OPEC must determine how to develop and enforce fair quotas for the group’s other members, and the fact that freezing output could mean ceding market share to other influential producers including Russia, which left Algeria before today’s meeting. But most important is the impact of a cut or freeze on the U.S. shale industry, which remains sensitive to price fluctuations and is currently expected to boost output even if prices remain rangebound within the $40-$50 zone.

opec production where to freeze

Shale’s share

The U.S. stock market actually rallied on Wednesday in response to OPEC cutting production, a sign of how significant energy producers are to the U.S. economy.

It’s understood that OPEC shifting its strategy to restrain supply would provide a lifeline to shale, which is the marginal barrel and most flexible supply in the global oil market. The U.S. stock market actually rallied on Wednesday in response to OPEC cutting production, a sign of how significant energy producers are to the U.S. economy. Ironically, though, shale will eventually be undermined by OPEC’s supply action in the longer term, since a tighter market would ultimately bring another wave of supply online and cause another price collapse, decimating the industry once again. In other words, we can comfortably expect more volatility to come.

Non-OPEC supply is poised to continue its better-than-anticipated performance throughout the extended low oil price environment, and if prices shift to the $50-$60 neighborhood, or even higher as a result of OPEC action, the supply gains would likely be even stronger. In other words, the price jump might be a false rally. “A price increase can erode the ‘recovery’ by putting more production on the market from U.S. tight oil producers and perhaps weaken demand,” said Sarah Ladislaw of the Center for Strategic and International Studies (CSIS) in a report this week.

Of course, the action by OPEC will change the trajectory of the oil market, pulling the tighter fundamentals forward, that is if producers follow through with their pledges.

The International Energy Agency (IEA), in its recent monthly analysis, said the oil market will remain in surplus next year, which caused consternation and urgency among OPEC members, but IEA also warned of a future price spike as a result of today’s upstream underinvestment. Of course, the action by OPEC will change the trajectory of the oil market, pulling the tighter fundamentals forward, that is if producers follow through with their pledges. Though shale would receive a brief respite from weakening prices, that situation will not hold indefinitely.

A lot of non-OPEC supply is set to ramp up even with prices expected to remain in the $40s or the low $50s for the rest of this year and into next. Goldman Sachs, in its latest note (entitled “Beyond Algiers” and released on Tuesday before the OPEC meeting), significantly revised its price forecast downward by $7 to $43 for the fourth quarter as it adjusted its outlook for fundamentals. It expects oil to be rangebound at $45-50 for the first half of 2017, with an average of $52 for the entire year. In a substantial revision, Goldman now sees a 400,000 b/d surplus for the fourth quarter of this year, versus previous estimates of a draw of 300,000 b/d. Its outlook for next year is bearish, revising the first quarter surplus up to 249,000 b/d. Stock draws will be modest in the second and third quarters, followed by another build in the last three months of 2017.

Over the summer, Goldman predicted that shale could rebound by some 600,000-700,000 b/d from the fourth quarter of this year to the end of 2017 as a result of the rig count doubling, with activity prominent in the Eagle Ford, the Permian, the Bakken, and the DJ Basin.

For next year, some 400,000 b/d of additional non-OPEC production outside of U.S. shale is poised to come on line, amid increased spare capacity in the service sector. Goldman’s more positive outlook comes from higher estimates for Kazakhstan, Russia, and Canada. The improved outlook for these producers offsets declines in other countries outside of OPEC—for 2017, non-OPEC should rise by 219,000 b/d, Goldman says, versus a massive decline of 939,000 b/d this year.

wave of shale

An OPEC-driven price rally, and its potential to stimulate U.S. shale, could throw markets back into turmoil. The Energy Information Administration (EIA) says total U.S. crude supply will fall by 260,000 b/d in 2017, thanks to lower shale output, despite an average WTI price of $50. An OPEC cut is not considered in this forecast, though. The outlook for shale would shift significantly if prices are higher. Against that backdrop, U.S. shale will be able to make up for any lost supply from OPEC.

The short-term trajectory of shale may be better than some expect. Over the summer, Goldman predicted that shale could rebound by some 600,000-700,000 b/d from the fourth quarter of this year to the end of 2017 as a result of the rig count doubling, with activity prominent in the Eagle Ford, the Permian, the Bakken, and the DJ Basin. Today’s decision from OPEC, if the market continues to take it seriously, might provide the floor under the market that will make Goldman’s summer estimates more realistic. The bigger question then becomes how the market can rebalance with new shale supply, and how that will impact OPEC collaboration moving forward.

 

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