The Fuse

OPEC Cuts Output, Erasing Most of Surplus

by Nick Cunningham | February 15, 2019

In December, OPEC and its non-OPEC partners agreed to slash output by 1.2 million barrels per day (Mb/d) below October levels. The deal contributed to an end in the dramatic slide in prices in the fourth quarter.

Looking forward, the OPEC+ production cuts are helping to tighten up the market. While there is a long list of potential factors that could surprise the market in 2019, the supply curbs create a tightening baseline that should lead to higher oil prices as the year wears on.

OPEC makes deep cuts
OPEC cut production by 797,000 barrels per day (b/d) in January compared to a month earlier, lowering output to 30.8 Mb/d. That came after a reduction of 709,000 b/d in December. The reductions have been swift and dramatic, helping to erase what had been a swelling surplus in the fourth quarter.

The real force behind the reductions is Saudi Arabia, which has throttled back on production by about 800,000 b/d since November. A handful of Saudi Arabia’s allies in the Gulf have also made sizable contributions – in January, the UAE lowered production by 146,000 b/d and Kuwait cut by 90,000 b/d.

To be sure, another tranche of reductions came from involuntary outages and disruptions in several countries facing different crises. U.S. sanctions on Venezuela led to the loss of 59,000 b/d in January, which could be dwarfed by forthcoming losses as PDVSA struggles to both process and find a home for its dwindling supply of heavy oil. Libya, too, saw another 52,000-bpd decline, largely stemming from the outage at the Sharara oil field, which was knocked offline in December by unrest but was recently captured by the Libyan National Army. Angola suffered a decline of 75,000 b/d – dropping production below its ceiling – likely due to losses from its aging oil fields.

Iran, also suffering from U.S. sanctions, managed to keep production flat. Waivers from the U.S. government have allowed buyers – including China, Japan, South Korea and India – to continue to import Iranian oil. Nigeria was the only country to post a significant increase in production in January, managing a 52,000-bpd jump in output. But an upcoming presidential election could spark instability. According to Verisk Maplecroft’s Civil Unrest Index, “there is an 82.3% probability that civil unrest risks will increase by 2019-Q3” in Nigeria, the firm said in a report.

Russia only cut production by 90,000 b/d in January, lower than the 230,000-b/d cuts that it promised as part of the OPEC+ deal. In fact, while OPEC achieved an 86 percent compliance rate with the December agreement signed in Vienna, the compliance rate for the non-OPEC coalition was only 25 percent, according to the IEA.

Nevertheless, the reductions are going a long way to draining the surplus. Notably, OPEC’s collective output still exceeds what the group believes will be needed to meet global demand. The group lowered the demand estimate for its oil to 30.6 Mb/d for 2019, down 0.2 Mb/d compared to last month’s report. As such, with production at 30.8 Mb/d in January, there is still a minor surplus.

However, Saudi oil minister Khalid al-Falih said that Saudi Arabia would go beyond its commitment and cut production by another 400,000 b/d in March, aiming for 9.8 Mb/d. Saudi Arabia is only obligated to lower output to 10.3 Mb/d, so it will voluntarily reduce output by 0.5 Mb/d more than required. Even if the rest of OPEC maintained output at January levels, the additional cuts could be sufficient to balance the oil market.

More outages, quality concerns
But the rest of the group probably won’t replicate January levels. Venezuela and Iran are likely to lose more barrels, while Russia has vowed to phase in its supply curbs over time. In the first week after sanctions were applied on Venezuela, shipments to the U.S. fell by over 40 percent, plunging to just 345,000 b/d.

But the sanctions not only targeted Venezuelan oil shipments to the U.S., but also exports of diluents to Venezuela. Without diluents, Venezuela will struggle to process its heavy crude, putting at least another 300,000 b/d at risk, according to Barclays. Events are fast-moving and the magnitude of the losses is uncertain, but a more severe collapse is not out of the cards.

Iran sanctions will tighten again in May, when U.S. waivers expire. The U.S. government has promised not to issue any new waivers, hoping to tighten the screws on Iranian exports, with the goal of dropping them to zero. The severe losses from Venezuela, combined with the OPEC+ reductions, could complicate that task. But the risk to Iranian oil is on the downside.

One of the dominant narratives in the oil market this year could be one of quality rather than quantity. The surge of production from U.S. shale over the last few years has produced an abundance of light oil, which can be spun into relatively higher quantities of gasoline. But medium and heavier oil blends, which produce more diesel, have become harder to find.

The loss of medium and heavier blends from Venezuela and Iran are exacerbating this trend, while the pipeline bottlenecks in Canada have added to the heavy market woes. OPEC+ reductions are also concentrated in countries with medium and heavier barrels. Topping it off, the forthcoming regulations on sulfur concentrations in marine fuels from the International Maritime Organization (IMO), which take effect in 2020, will force ship-owners to swap out dirty fuel oil, putting more pressure on distillate-rich medium and heavier oil blends. This dynamic could create disruptions in both the crude oil and the refined product markets.

Ultimately, a potential downturn in the global economy threatens to undercut demand, which could spoil any oil price rally. However, barring a significant economic slowdown, the combination of OPEC+ production cuts, the expected supply losses in Iran and Venezuela, and the disruptions in the product markets could create a cocktail that steadily tightens up the oil market this year.

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