The Fuse

OPEC Promises Market Stability and Clarity, but Deal Extension Is an Inkblot Test for Analysts

by Leslie Hayward | May 25, 2017

Coming into this week, there was skepticism that today’s meeting of the Organization of the Petroleum Exporting Countries (OPEC) would play out in a straightforward a manner. Almost 30 months into the oil price collapse and OPEC’s decision to let “market forces” unwind the oil glut, and six months into the cartel’s intervention, inventories haven’t stopped rising and supply continues to outstrip demand—even by OPEC’s own numbers.

OPEC is struggling with traders who don’t trust it, a market it doesn’t fully understand, and a glut that won’t quit.

Today’s meeting appeared mundane on the surface, and some analysts have lauded the cartel’s renewed collaborative spirit and effort to rebalance the market. OPEC is enjoying expanded membership, fresh leadership, and strong participation that suggest its influence is growing, but the group is also struggling with traders who don’t trust it, a market it doesn’t fully understand, and a glut that won’t quit.

‘The oil market response to our decision was surprising’

Oil prices dropped as much as five percent following the deal, which Iranian Oil Minister Bijan Zanganeh called “surprising.” Saudi Energy Minister Khalid Al-Falih measuredly shrugged off the downtick: “I don’t pay attention to the day-to-day fluctuations of the market. Technical fluctuations can appear in the market that aren’t consistent with long-term trends.”

“You have to question the logic behind the timing of announcements this week,” Helima Croft, Chief Commodities Strategist at RBC Capital Markets, told The Fuse. “The nine-month extension was a surprise when it was announced—they missed an opportunity for a great unveil.”

Beyond undermining itself by misreading market psychology, OPEC has bigger existential issues. When OPEC agrees to limit production, oil prices, in theory, should rise. But the market needs more from the group for its interventions to continue working. When asked about an “exit strategy” in the press conference before the ministerial meeting, al-Falih stated, “We don’t intend to exit so there is no exit strategy.” When pressed on this issue later in the day, he punted, saying, “The fact that we don’t yet have a strategy for later 2018 does not mean we won’t have a strategy; it just means that we will evaluate market conditions at that time.”

“The fact that we don’t yet have a strategy for later 2018 does not mean we won’t have a strategy, it just means that we will evaluate market conditions at that time.”

That lack of clarity on an exit strategy is exactly the problem, and the biggest hypocrisy in OPEC’s effort.

“Unless they articulate an exit strategy, we will forever assume that a flood will come at the end of this agreement,” said Michael Cohen of Barclays. Cohen also noted an important new term in the deal: “Beyond the extension, the biggest takeaway from this meeting is the monitoring committee, which now has the wherewithal at any given month to recommend changes to the overall agreement. It allows them to maybe have a gradual return to previous production levels. Otherwise, the balance is very sloppy in 2018.”

No Consensus

Even with full compliance, analysts are all over the map on what the deal means for the future of prices and supply—undermining the group’s promise that its moves are restoring clarity and stability to the global oil market.

Even with full compliance, analysts are all over the map on what the deal means for the future of prices and supply.

“Instead [of triggering an 2H17 stock draw], we think persistently high inventories will trigger an end-year Vienna Group crackup, temporary abandonment of supply restraint, and another big price down leg into the $30s by the middle of 2018,” said Bob McNally of the Rapidan Group, who has argued since early last year that OPEC is in the business of managing market sentiment more than supply following February 2016, when oil prices briefly crashed to $26 per barrel. “The problem is inventories have not declined as expected, the price rallies fizzled, and those investors who have been trying to catch the bottom have gotten burned. Investors may want to see visible, large, and sustained stock draws before jumping in again.”

“The problem is inventories have not declined as expected, the price rallies fizzled, and those investors who have been trying to catch the bottom have gotten burned.”

“Coming out of this deal, we see oversupply through 1H 2018,” said Jamie Webster of Boston Consulting Group. “Shale production is increasing at the same rate as it was before 2014, which is going to outpace increases in demand and OPEC’s deal.”

Goldman Sachs also sees oversupply if OPEC can’t figure out an exit strategy. “A 9-month extension would normalize OECD inventories by early 2018, in our view, but we see risks for a renewed surplus later next year if OPEC and Russia’s production rises to their expanding capacity and shale grows at an unbridled rate,” the investment bank wrote in a recent note.

However, there are others who see today’s move as facilitating a smooth rebalance. “They don’t want to rock the boat here by doing anything out of the extraordinary,” said Abhishek Deshpande, Energy Market Analyst at Natixis. “Even though stock levels have not gone down to the 5-year average, they are convinced—and I’m in agreement—that the stocks are slowly but surely drawing even though it’s at a disappointingly lower rate than they were expecting.”

“This is the right move,” said Jeff Quigley of Stratas Advisors. “A deeper cut would prompt a sharp rebound from shale, which will feed more market volatility and price swings. We would rather see the cost of the marginal barrel push prices back up gradually, which is a more stable and sustainable way to raise prices, rather than dramatic OPEC action.”

On the opposite end of the spectrum is IEA, which already sees 1 million barrels per day being drawn from OECD inventories and a .7 mbd decline in the second half of the year. Cornelia Meyer, CEO of MRL Corp., says that in IEA’s scenario, “We might see the market really heating up and want prices to come down by then.” Meyer also argued that the 40 percent decline in upstream investment during 2014-15 could materialize in a severe shortage in the medium-term.

This range of predictions coming out of the deal—from dramatic stock draws to another oil price plunge—is inconsistent with the increased transparency and stability that OPEC claims to be advancing with its market management. “In the absence [of the November 2016] agreement, the markets would have remained aimless,” Khalid al-Falih said at the conclusion of today’s session. But is the oil market really less aimless now?

Expanding and institutionalizing

OPEC, despite its clumsiness, is expanding its base and its access to producers outside the cartel, with unclear consequences for consumers that depend heavily on oil.

In a post-meeting press conference hosted by Saudi Energy Minister Khalid al-Falih, Russian Energy Minister Alexander Novak, and OPEC Secretary General Mohammed Barkindo, the group said it is working to “institutionalize” the increased cooperation between OPEC and non-OPEC oil producing states. The countries represented in today’s agreement add up to roughly 58 percent of daily oil supply. OPEC also announced the formal addition of Equatorial Guinea, bringing its membership to 14.

Commenting on rumors that OPEC representatives have been meeting with shale producers, Barkindo confirmed the dialogue, stating, “In this new area, we have to break barriers, so we broke bread with shale.” OPEC, despite its clumsiness, is expanding its base and its access to producers outside the cartel, with unclear consequences for consumers and economies that depend on the world’s most important commodity.

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