The Fuse

Is the OPEC Cut Already Doomed to Fail?

by Matt Piotrowski | October 12, 2016

In the OPEC press release following the cartel’s decision to slice output while meeting in Algiers late last month, the group stated that it had “opted for an OPEC-14 production target ranging between 32.5 million and 33 million barrels per day (mbd), in order to accelerate the ongoing drawdown of the stock overhang and bring the rebalancing forward.” The market cheered the move and pushed prices above $50 per barrel. Analysts, meanwhile, have been trying to figure out what the action will ultimately mean for prices, fundamentals, and the cartel. OPEC has set up a working group to hammer out a long list of issues that will determine whether the cut will be successful, not least of all is which countries will cut, and by how much. Members are expected to finalize the details at its meeting on November 30, but in the meantime, the entire arrangement looks like a mess, with hole after hole being punctured before it’s even been fully agreed upon and implemented.

OPEC members are expected to finalize the details at its meeting on November 30, but in the meantime, the entire arrangement looks like a mess, with hole after hole being punctured before it’s even been fully agreed upon and implemented.

It’s clear, though, that any success will be defined by the Saudis’ willingness to make concessions to other members and bear the brunt of volumes held back from the market. The tentative agreement has worked so far in terms of manipulating sentiment to talk up prices. To achieve the goal of rebalancing the market, however, the task is much more difficult. Based on the latest International Energy Agency (IEA) data, OPEC is pumping some 33.64 mbd, up almost 1 mbd from the beginning of the year. Assuming that the group agrees to a cut in November and targets 32.5 mbd, the cartel would have to take 1.14 mbd off the market. With Libya, Iran, and Nigeria likely to gain exemptions in the agreement as they are poised to increase output to make up for longstanding outages, the pain of the production cuts will be shared by the other 11, which total about 27 mbd, or 80 percent of the cartel’s production. Based upon calculations from Stratas Advisors, here’s a breakdown of a cut from those 11, with the Saudis reining in more than 400,000 b/d in Q1 of next year.

OPEC cut

Trouble ahead, trouble behind

“If Saudi Arabia, Kuwait and the UAE want to control prices, they’ll need to take the brunt of any potential cut.”

The production cut, though, runs into a number of complications. If the trio not bound to quotas is successful in raising output, the other 11 would have to cut by more than 1.14 mbd in order to offset the increases and reach the 32.5 mbd target. Another big wildcard is Iraq, which lashed out at the deal after the Algiers meeting. The IEA says Iraq is producing 4.46 mbd now, but the country, which hasn’t been been bound by a quota since 1991 because of sanctions and war, may have the potential to exceed expectations and completely throw off the entire deal, by either not agreeing to it or simply not complying with any cut. Given that compliance has historically been very poor among members, this wouldn’t be a surprise. In fact, besides the Saudis and its Gulf allies, no other member may actually follow through with curbing output. “If Saudi Arabia, Kuwait and the UAE want to control prices, they’ll need to take the brunt of any potential cut,” Jeff Quigley of Stratas told The Fuse, noting that smaller OPEC countries have had historically low compliance rates with OPEC quotas.

There is another big obstacle, too. OPEC wants non-OPEC producers to help rebalance the market, most notably Russia, by either freezing or cutting back. The country’s president Vladimir Putin has stated that Russia will go along with OPEC members, but individual companies have given contradictory statements regarding their intended participation. Russia has increased output by more than 300,000 b/d recently to 11.1 mbd and will likely keep output near that level for coming year.

russia

It’s obvious what Putin is doing—he understands his comments of support can help underpin prices knowing full well Russian companies won’t actually comply. Verbal intervention has been common among major oil producers this year in a desperate attempt to jawbone prices higher and send messages to rivals through the media. Russia, though, does not have the technical capability to be a swing supplier; nor is it in its interest to hold back supply since it could hurt its market share in Europe and Asia.

First OPEC production cut in the age of shale

While Russia is being discussed as a possible friend to OPEC members, U.S. shale production will make a bigger impact in the long term in determining the success of the coordinated production cut—the first in the age of shale. Possible increases from Libya, Iran, and Nigeria are the biggest internal hurdles for OPEC, but U.S. shale could also bring a new wave of supply on line. In a note this week, analysts at JBC look at how quickly shale could increase should prices move to a higher range as a result of OPEC action.

While Russia is being discussed as a possible friend to OPEC members, U.S. shale production will make a bigger impact in the long term in determining the success of the coordinated production cut—the first in the age of shale.

Under the assumption that OPEC action can lift prices to $60, total U.S. shale production could “relatively easily” increase by 1-1.5 mbd within the next year and a half. That would “stand a good chance of at least matching an OPEC production cut,” notes JBC, adding that its numbers could be conservative given that large producers are in a wait-and-see mode and hedges have already given shale an upside for 2017. The consultancy bases its assumptions on the number of completions expected at the Bakken, which could triple by the third quarter of next year and reach 150 per month, similar to levels seen in the first half of 2015, when oil prices averaged $57. At that time, the Bakken remained stable, but since then, rigs have become more efficient and there is also a backlog of drilled but uncompleted wells, making the production outlook optimistic. Under the scenario of 150 completions per month, the Bakken could rise by 200,000 b/d to 1.1 mbd over an 18-month period. JBC then scales up the Bakken analysis for total U.S. shale, reaching the 1-1.5 mbd number.

Why did the Saudis shift?

Given that there are so many complications and different scenarios surrounding an OPEC production cut, it’s curious why the Saudis have shifted their strategy away from pushing prices low to choke off competition. During the past two years, U.S. shale has taken a big hit, falling by 1.1 mbd from its peak, deepwater projects have been nixed, billions in capex have been deferred, and the Kingdom was able to increase market share. Saudi Arabia looks well positioned for 3-4 years down the road. But there’s no doubt the country is hurting economically from lower prices, providing one major motivation. It may also be looking to shore up oil prices ahead of an IPO for Aramco.

Given that there are so many complications and different scenarios surrounding an OPEC production cut, it’s curious why the Saudis have shifted their strategy away from pushing prices low to choke off competition.

While a cut comes with a lot of potential rewards, it also certainly has a lot of potential risks. It’s not doomed from the beginning to fail—after all, Iran might have already maxed out, while Libya and Nigeria are highly volatile and may not be able to boost output. Further, the U.S. shale is undergoing major stress, and despite its upside potential, the industry is in uncharted territory. If, however, the cut backfires, whether through a failure to reach a deal, non-compliance among members, or a surge in non-OPEC supply, all producing countries will be sorely tested and the credibility of the entire organization could be shattered. The only thing for sure is that high volatility and high uncertainty are guaranteed for the year ahead.

 

 

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