The Fuse

OPEC, Far from Dead, Agrees to Major Cut, Sparks Market Rally

by Leslie Hayward and Matt Piotrowski | November 30, 2016

The Organization of the Petroleum Exporting Countries (OPEC) agreed on Wednesday to cut crude production levels by roughly 3.5 percent, starting in January, to boost prices and manipulate fundamentals to accelerate the rebalancing of the global oil market. Oil prices on the NYMEX rallied by as much as 8 percent to above $49 per barrel in anticipation of the agreement, responding to OPEC ministers’ optimism that a deal would be agreed after attending an informal meeting in the morning. The coordinated action, decided at OPEC headquarters in Vienna, builds off of the provisional agreement in Algiers in late September and confirms a complete reversal from the Saudi-led strategy begun two years ago to keep the group’s production elevated in order to undermine higher-cost non-OPEC supply, like U.S. shale oil. The cartel began discussing capping or cutting output in February as prices fell into the $20 per barrel range and the global surplus kept growing, despite expectations to the contrary. Meetings in Doha in April and Vienna in June did not lead to agreements, but members have now put aside differences for the time being amid a collective interest to see higher prices, as their economies suffer from longer-than-expected price weakness.

The coordinated action, decided at OPEC headquarters in Vienna, builds off of the provisional agreement in Algiers in late September and confirms a complete reversal from the Saudi-led strategy begun two years ago to keep the group’s production elevated in order to undermine higher-cost non-OPEC supply, like U.S. shale oil.

The agreement is to target 32.5 million barrels per day starting in January 2017, which is roughly 1.2 mbd lower than October production levels, the most recent data, according to secondary sources. The deal is set to last for six months and then be reviewed at the cartel’s next meeting in Vienna in late May. OPEC will also attempt to bring some major non-OPEC members into the coordinated cut. In fact, OPEC members will meet with Russia and others in Doha or another venue on December 9 to hammer out details. The biggest factor behind OPEC’s agreement is that the deal is subject to non-OPEC suppliers cutting by 600,000 b/d. It’s unclear, however, if the entire OPEC deal will ultimately break down if Russia and the others do not follow through—although Russia reportedly confirmed today by phone that it would commit to a 300,000 b/d cut. At the press conference following the meeting, OPEC officials were vague about how tied the group’s will to cut would be if non-OPEC suppliers don’t go along. “With the commitment shown today we think we can get the 600,000 b/d out of them. We are sure we can get 600,000 b/d, maybe more,” OPEC said at the press conference following the meeting.

The move serves as a reminder to journalists, traders, and analysts that OPEC still actively engages in undermining a free, fair, and transparent oil market.

OPEC has set up a monitoring committee to scrutinize allocation compliance, an issue that OPEC has had to deal with in the past. Kuwait will chair the committee, while Venezuela and Algeria will be involved in the group.

The OPEC move serves as a reminder to journalists, traders, and analysts that OPEC still actively engages in undermining a free, fair, and transparent oil market.

The breakdown of the OPEC cut, of course, is tricky. The math gets particularly complicated when accounting for Iran being allowed to increase production by another 90,000 b/d before it has to freeze (the table provided by OPEC below appears to have used a pre-sanctions number for Iran as the baseline level, which is about 300,000 b/d higher than what it produced in October).

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To offset that increase in Iran, other members will have to share a larger burden. Further muddling the deal is Indonesia, which is a net importer of crude, getting suspended from the organization. The OPEC target of 32.5 mbd is confusingly based on numbers that include Indonesia, but Indonesia has suspended its membership. The remaining 13 OPEC producers—which produced 32.92 mbd in October—will have to throttle back even deeper to make up for Indonesia leaving. The total cut, based on the table above, would be 1.26 mbd, but that doesn’t take into account Iran increasing by 90,000. The cut, to be more effective, needs non-OPEC producers to participate in order to offset the higher Iranian levels.

Analysts are confounded by the deal, given wild cards such as non-OPEC participation, compliance among members, and the fact that it is set to last only six months. However, a number have struck an optimistic tone.

Analysts are confounded by the deal, given wild cards such as non-OPEC participation, compliance among members, and the fact that it is set to last only six months. However, a number have struck an optimistic tone.

“They pulled a rabbit out of a hat,” Yasser Elguindi of Medley Global Advisors told The Fuse following the meeting in Vienna. “Russian contribution when confirmed is the real surprise in this agreement. The devil is in the details and compliance will be key. But this is an achievement all OPEC members will be proud of.”

Matthew M. Reed, Vice President of Foreign Reports, argued for the legitimacy of the announcement. “For a deal to be good, it had to take a million barrels off the market or more. Check. For it to be better, it needed a commitment from Iraq and a freeze for Iran. Check and check. To be a great deal it needed to get the Russians off the sidelines. Check. From Riyadh’s perspective, this all came together nicely, even if it was a long road to Vienna, with some detours.”

Other analysts note how good the deal sounded at first, but point out that implementation and non-OPEC’s participation are entirely different stories.

“If you look at the cuts from the core OPEC producers, they would take out [almost 800,000 b/d] from the market,” Jamie Webster of Boston Consulting Group told The Fuse. “That would make it a fanstastic deal, but not as big as the headline figure of 1.2 mbd.”

Webster agreed that the non-OPEC involvement, along with compliance, will be a major wild card and will keep the market in a wait-and-see mode.

Saudis to stay above 10 mbd

Another factor in this deal is how painful the cut will be for the Saudis. With production currently at 10.53 mbd, the Kingdom would have to bring down production by almost 500,000 b/d, or about 5 percent. The Saudis, however, typically bring down supply levels in the winter. In other words, the Saudi drop in output that was agreed at the meeting would have occurred anyway since domestic demand falls during the first quarter. In January of this year, right before discussion of OPEC freezing output began, the Saudis produced 10.09 mbd, which is only slightly above the 10.06 mbd it will target from today’s agreement.

The Saudi drop in output that was agreed at the meeting would have occurred anyway since domestic demand falls during the first quarter.

Also a big surprise is that Iraq will contribute more than 200,000 b/d in cuts, lowering output to 4.35 mbd. Since the meeting in Algiers in late September, Iraq has been adamant that it has been producing at higher levels than others believed. Based on the latest data it provided to OPEC, it pumped 4.78 mbd in October, but other sources said the Iraqis produced 4.56 mbd for the month. The baseline has been a sticking point between the Saudis and Iraq, since Iraq may have to cut deeper than it wanted to. Gulf Coordinating Council (GCC) countries, key players since they aren’t dealing with exceptional situations like Libya, Nigeria, and Iran, are expected to cut output by 300,000 b/d.

Questions about economic impact, U.S. shale

Going forward, the market will be looking at whether countries adhere to their production targets, but given the compliance issues in the past, expected increases in non-OPEC supply, and the possibility that U.S. shale rebounds significantly, it’s unclear if OPEC’s action will be enough to clear the global glut of crude supply. OPEC says that the deal is “out of sense of responsibility for OPEC member countries, for non-OPEC countries, and for the general and well-being of world economy.”

The OPEC deal is naturally bad news for consumers in the U.S. who will pay higher pump prices, at least for the time being, based on the initial reaction from the market.

The OPEC deal, however, is naturally bad news for consumers in the U.S. who will pay higher pump prices, at least for the time being, based on the initial reaction from the market. The U.S. economy has benefited from lower costs from a weaker global oil market. Nevertheless, the timing of the OPEC could be good news for U.S. shale producers. According to money managers, the next six weeks is when U.S. E&Ps are submitting their budgets for review by their respective boards of directors, and will be appealing to private equity for additional funding. Although today’s deal may scarcely be a cut, OPEC’s move may succeed in shifting market sentiment and should contribute to fresh capital inflows that will likely enable resumed drilling activity. According to one source, OPEC could have done real damage to the shale industry’s prospects for 2017 if today’s deal had fallen through and prompted a major selloff.

One thing for sure is that following Wednesday’s OPEC meeting, given the vague and contradictory details along with the uncertainty over non-OPEC, the oil market is in for a bumpy ride. In all, the market scenarios continue to be apparently endless, with direction riding on a large number of unclear factors.

 

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