The Fuse

OPEC Meeting Unlikely to Lead to Change in Strategy, But Cartel Is Not ‘Dead’

by Matt Piotrowski | May 25, 2016

The upcoming OPEC meeting next week in Vienna is not expected to bring about any change in policy, but that doesn’t mean the meeting will be a quiet one. Much attention and intrigue will center around Khalid al-Falih, the new Saudi oil minister who recently replaced longstanding veteran Ali al-Naimi, and the economic and transparency shifts now occurring in the Kingdom.

While there’s no question that the group’s approach has shifted, declarations that OPEC is now irrelevant or does not hold enough power to manage the market could once again be premature, as such pronouncements have proven in the past.

Besides that, questions will revolve around the rivalry between the Saudis and the Iranians for market share in Asia and Europe and whether the cartel is effectively “dead” since it can’t come an agreement to freeze or cut production levels and it has very thin levels of effective spare capacity. While there’s no question that the group’s approach has shifted, declarations that OPEC is now irrelevant or does not hold enough power to manage the market could once again be premature, as such pronouncements have proven in the past. Instead, it’s likely that low oil prices will lock-in reliance on OPEC’s low-cost reserves for decades to come.

No production freeze likely

Putting a cap on production is a possible surprise outcome, but so far there’s no indication that one will occur at the meeting next week, which is occurring a month and a half after the “failed” Doha talks.

Iran said over the weekend that it has no interest in freezing production as it continues to ramp up exports now that international sanctions were lifted earlier this year. Iran’s stance will only motivate Saudi Arabia to dig in its heels and keep its production levels high in order to hold on to market share in Asia and Europe. Deputy Crown Prince Mohammed bin Salman, who now oversees Saudi oil policies and wants to structurally diversify the Kingdom’s economy away from reliance on oil revenues, insisted at Doha that the Saudis would only agree to a freeze if Iran did. Without Tehran on board, the talks broke down, and the strain between the two will define OPEC dynamics in coming months—and possibly years.

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Besides the Iran-Saudi tension, a surprise supply agreement is not likely because prices have firmed to just under $50, up some 70 percent from the lows seen in February. While this price is still below breakeven levels for many producing countries, it gives them some relief for the time being that the worst-case scenario of an extended period of $20-$30 oil won’t play out.

“A freeze deal might have buoyed prices at virtually no cost to maxed-out producers, but the underlying market psychology has changed,” Matthew M. Reed of Foreign Reports told The Fuse. “Prices have rebounded. Most forecasts hold that the market balance will recover by year-end. So the sense of urgency has disappeared.”

“Prices have rebounded. Most forecasts hold that the market balance will recover by year-end. So the sense of urgency [for an agreement] has disappeared.”

Moreover, a supply cut would be counterproductive since Saudi Arabia doesn’t want the price to be too high and eventually stimulate more U.S. shale production. The market, in the past few months, has received support from hedge fund buying, unplanned supply outages, strong gasoline demand, and expectations for a tighter market during the second half of the year. The International Energy Agency (IEA), for instance, sees the surplus falling from 1.3 mbd in the first half of the year to just .2 mbd by the end of 2016. Furthermore, the precarious situations in Nigeria and Venezuela could lead to more supply disruptions, while the U.S. has already seen a .9 mbd drop in supply in the past year, with more declines likely to occur.

That said, the same issues that are pumping up prices make the market vulnerable to a correction. Hedge funds could all sell at once, supply disruptions could quickly resolve, demand will face headwinds from anemic economic growth, and even though supply-demand balances appear to be tightening, the massive stock overhang will take some time to work off. OECD commercial inventories for crude and products, according to OPEC’s latest monthly market report, are above 3 billion barrels, some 361 million bbl higher than their five-year average (see below). This doesn’t include oil that is stored at sea on tankers. Needless to say, there’s a big cushion in the market right now.

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OPEC is not dead

Russian Oil Minister Igor Sechin said recently that OPEC is dead. “As for OPEC, it has practically stopped existing as a united organization,” he told Reuters a couple of weeks ago. Analysts and other market observers have come to similar conclusions. “The death of OPEC has been long foretold, but it looks like the Saudi 2030 Vision is really the obituary notice,” Citigroup’s Seth Kleinman told Bloomberg. “The Saudi Aramco IPO, and the presumption that there’s going to be a much higher degree of autonomy within Saudi Arabia—there’s no real role for OPEC.” Furthermore, if even minority shares of Saudi Aramco are publicly traded, it raises questions about the viability of Saudi Arabia’s participation in future OPEC meetings. Under such circumstances, Aramco would not only have a fiduciary duty to shareholders to maximize output—but agreeing to a production target with other OPEC member states could open allegations of price fixing.

After the meeting next week, should OPEC members not take action to rebalance the market, more commentary will likely say the same thing. There’s no doubt the Saudis have shaken up the world’s oil market in the past two years by pursuing market share and talking about opening up its state-owned oil company to outside investors and diversifying its economy. They have done this despite calls from other OPEC countries wanting to take action to boost prices. But the Saudis are by no means giving up on oil, and therefore won’t be quitting OPEC anytime soon.

“When the Saudis talk about reform, they aren’t talking about quitting oil. They’re talking about protecting themselves from painful price swings.”

“When the Saudis talk about reform, they aren’t talking about quitting oil. They’re talking about protecting themselves from painful price swings,” said Foreign Reports’ Reed. “The government stands to earn a lot from oil sales whether it’s taxes, royalties, or dividends. The government, as Aramco’s majority shareholder, will have a stake in price and for that reason OPEC could still advance their interests.”

Accordingly, although the organization is in some state of disarray, thrown off-guard by the growth of U.S. shale this decade and bitter regional conflicts putting top members at odds, current conditions increase the likelihood of the group’s continued relevance. The longer low oil price persists, the more future supply will be choked off, the more demand will be stimulated, and the harder it will be to bring about diversity in the transportation sector. The world will need a lot more oil, and it’s likely to come from low-cost producers in the Middle East, as low prices deter investment in non-OPEC reserves. Long-term outlooks from both the IEA and the Energy Information Administration (EIA) say that OPEC will grow in market power over the coming decades should demand growth continue on its projected path.

The longer low oil price persists, the more future supply will be choked off, the more demand will be stimulated, and the harder it will be to bring about diversity in the transportation sector. The world will need a lot more oil, and it’s likely to come from low-cost producers in the Middle East.

The EIA says, in its reference case, for instance, that OPEC output, which is now around 33 mbd, up by about 2.5 mbd since the end of 2013, will accelerate after 2025 and reach about 47 mbd by 2040. That would give the group roughly 47 percent of total world supply, versus 40 percent currently (when NGLs and unconventionals are included), with Saudi Arabia, Iraq and Iran seeing the main growth. In the agency’s low oil price scenario, global reliance on OPEC is even greater, rising to an astounding 53 percent by 2040. The IEA sketched out a similar long-term low oil price scenario, suggesting that the transition to biofuels, electric vehicles, and natural gas vehicles would slow significantly, underpinning oil demand. At the same time, since oil from the Middle East is cheaper to produce than in non-OPEC countries, it becomes more viable in an extended low price environment, so the world would be more dependent on oil from the region. Even in its main scenario, the IEA sees non-OPEC peaking by 2020, which of course gives OPEC members greater market share in coming decades.

In other words, the situation is likely to be more in OPEC’s favor in the medium to long term. “Very unique circumstances conspired to make OPEC powerless these last few years,” Reed told The Fuse. “But circumstances change. The Saudis typically take the long view. For that reason, it’s hard to believe they’d give up on the organization… OPEC isn’t dead so much as it’s waiting for the right crisis.”

The low oil price and supply glut won’t last forever. The current gap in supply investment, coupled with the thirst for oil in emerging markets, will give OPEC, regardless of today’s policy and discontent, more market power over time. Don’t say it’s dead yet.

 

 

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