News headlines in the oil markets were no doubt mostly bearish this week, a turnaround from what we saw at the beginning of the year when markets were still on their OPEC-induced high. Hedge funds and other investors have clearly overbought, the EIA expects shale to boom back to 9.5 million barrels per day (mbd) in 2018, U.S. stocks rose by a massive 14 million barrels last week, and OPEC producers not bound by quota (Libya and Nigeria) are pumping more volumes. There’s another issue worth noting—the OPEC cut might not be steep enough to rebalance supply and demand and also drain bloated inventories. Nothing will change materially in the market until there’s a significant stock draw, a development that appears doubtful, which could ultimately force OPEC to change strategy once again.
Some OPEC ministers are already grumbling that the cartel’s production agreement, to manipulate fundamentals and boost prices, may not bring about a longer-term rebalancing and a sustained deficit. Iran’s Oil Minister Bijan Namdar Zanganeh said this week that OPEC will have to cut production in the second half. “OPEC talk that production cuts may be extended beyond their initial six-month term is a mixed signal,” said Tim Evans of Citi Futures, “an indication of commitment toward rebalancing the market but also an acknowledgment that there is more, ongoing work to be done.”
“OPEC talk that production cuts may be extended … is a mixed signal, an indication of commitment toward rebalancing the market but also an acknowledgment that there is more, ongoing work to be done.”
The market has yet to achieve a deficit, although we are only a month and a half into the production cut. Based on the latest data from the EIA, OPEC slashed output by 910,000 barrels per day (b/d) in January, 76 percent compliance, but the global market was in surplus by more than 700,000 b/d. If OPEC continues at its current production levels for the rest of the year, and demand grows at the expected clip of 1.6 mbd, the global market will eventually see a draw.
But this outlook makes a number of big assumptions that may not pan out. First, OPEC is now producing at lower levels than its 32.5 mbd target established at its Vienna meeting in November. In January, most producers adhered more or less to their respective targets, with the Saudis cutting output by 520,000 b/d, some 34,000 b/d more than what they committed. Iraq is a big question mark, but it has made some cuts. The country reduced output by 120,000 b/d last month, short of its 210,000 b/d pledge. Kuwait and UAE, close allies of the Saudis, have reduced output according to plan, by the tune of 140,000 b/d for each, while Iran is right at its output target.
It’s not certain that compliance will last, however. Throttling back at this time of the year is not a huge burden given that demand ebbs ahead of the second quarter. Later in the year, as demand picks up, will producers resist the urge to cheat? The EIA is forecasting a 1.28 mbd demand jump from the second to third quarters. And just as important, Libya and Nigeria, both of which increased output in January, loom over the deal since they are not held back by quotas. Another issue is non-OPEC supply, particularly U.S. shale. The EIA sees U.S. production returning to growth this year, putting output outside the cartel up 280,000 b/d this year.
This confluence of factors—OPEC’s cuts, moderate non-OPEC growth, and robust demand—would bring about an OECD commercial inventory draw of a modest 21 million barrels, or 57,500 b/d, for 2017, not nearly large enough to significantly alter market sentiment.
Of course, the draw may be smaller if OPEC members don’t continue to commit to their pledges, non-OPEC supply surprises more to the upside, or demand does not reach expectations. Furthermore, the oil market looks to be very sloppy in 2018, with non-OPEC forecast to grow by 1 mbd (with almost half of that in the U.S.) and OECD commercial stocks set to build by 41 million barrels, more than counterbalancing declines this year, according to the EIA. With these factors ahead, OPEC’s will to continue to cut will be sorely tested.
OPEC to go back to pumping all out?
It’s clear with the quick resurgence of the shale patch with oil prices back above $50, OPEC is back to competing with shale.
So, what does OPEC do at its meeting in late May and throughout the rest of this year? The deal struck last year, which included cuts from some non-OPEC suppliers, was for only six months, with the option to extend for another half year if there’s unanimous agreement. It’s clear with the quick resurgence of the shale patch with oil prices back above $50, OPEC is back to competing with shale, posing the same dilemma it wrestled with in late 2014. The Saudis then resisted the calls from other OPEC members to cut back, preferring to hold onto market share and weed out higher-cost non-OPEC suppliers instead of trying to support prices.
If members continue on the current path during the second half of the year, they would do so because of the understanding they’d have to stick it out in order to see the benefits of the current strategy. Given that oil prices failed to reach $60 for the time being and there are signs the rebalance won’t happen until the second half of the year, if it happens at all, an extension in May is likely.
The real test will come next year with a return to surplus. OPEC would have to throttle back even more to keep the market balanced, a burden that would fall mostly on the Saudis.
The real test, though, will come next year with a return to surplus. Against that backdrop, OPEC would have to throttle back even more to keep the market balanced, a burden that would fall mostly on the Saudis, particularly if some producers—most notably Iraq—end up cheating. In a situation such as that, Saudi Arabia may return to relying on strong demand growth and lower prices curtailing upstream investment to underpin its longer-term market share, instead of cutting back to prop up prices.
When asked last month about extending the OPEC deal beyond six months, Saudi Energy Minister Khalid al-Falih downplayed the urgency. “We don’t think it’s necessary, given the level of compliance we have seen and given the expectations of demand,” al-Falih said. “The re-balancing which started slowly in 2016 will have its full impact by the first half. Of course, there are many variables that can come into play between now and June, and at that time we will be able to reassess.”
Though Falih was confident in a swift rebalancing, he didn’t rule out continuing the current strategy. But his message could also be understood as a tough message to other members that the Saudis won’t continue on the current path indefinitely. To be sure, the dynamic that played out from 2014-16 of OPEC versus shale has not gone away, and may in fact have been intensified with the cartel’s decision last year. That should lead, at some point, to a rethink in approach during another era of surging shale production.