- EIA, OPEC show supply-demand deficits in Q3 2017
- OPEC likely to extend cuts to manage perceptions for 2018
- Brent’s backwardation a temporary victory for OPEC
- U.S. crude stocks down almost 15 percent since April
- Saudis cut exports to U.S. by 37 percent
Throughout the 2014-2016 oil price downturn, commentators repeatedly claimed OPEC was powerless to halt the price decline. Even after the cartel agreed to reduce output late last year, many critics again announced the cartel’s demise (“OPEC is dead,” said one analyst in May). But are OPEC’s efforts finally paying off? Lately, the market (especially in the U.S.) has been distorted by Hurricane Harvey, which forced the closure of approximately 20 percent of total refining capacity at its peak—but the cartel has benefited from a number of supportive factors. The Brent market is holding steady in the mid-$50s, the futures curve has flattened (taking away refiners’ and traders’ incentive to store crude), U.S. inventories have declined sharply from levels seen in the spring, and demand growth remains buoyant thanks to an improving macroeconomic outlook.
Even after the cartel agreed to reduce output late last year, many critics again announced the cartel’s death. But lately, the cartel has benefited from a number of supportive factors.
OPEC’s collaboration with several non-OPEC countries, especially Russia, to increase prices and tighten fundamentals is reshaping the global oil market in their favor. In late 2016, OPEC and its non-OPEC counterparts agreed to cut production by 1.8 million barrels per day (mbd). Based on the latest monthly reports from the EIA and OPEC, for instance, the supply and demand fundamentals for the third quarter of 2017 are mostly balanced, with global demand slightly exceeding total supply.
With the market finally turning in its favor, the cartel is more likely than not to stay the course and maintain its reduced production for the first half of 2018, if not the entire year, in an effort to manage perceptions for next year.
“An extension beyond March makes sense,” Matt Reed of Foreign Reports told The Fuse. “Either they re-commit to current levels or they moderate the limits so that OPEC and others can gradually, maybe even gracefully, exit the deal in 2018, without upsetting prices. Declaring victory would be a mistake.”
For the Saudis in particular, production cuts must remain in place in order for them to move forward both on Aramco’s initial public offering (IPO)—slated for next year—and full economic reform. Saudi Arabia reportedly wants oil to be trading around $60 oil at the time of its IPO.
Even as OPEC’s strategy is beginning to work, the group has no choice but to stay the course—it has never successfully articulated an exit strategy.
Even as OPEC’s strategy is beginning to work, the group has no choice but to stay the course—it has never successfully articulated an exit strategy. A failure to extend the output cuts risks precipitating a wave of liquidation among investors and a sharp price decline, wiping out the cartel’s recent price success and the Saudis’ opportunity for $60 oil during the IPO.
Brent at $55
The primary American price benchmark—NYMEX WTI—has lagged the rest of the world, in part due to refinery outages from Hurricane Harvey, but also as a result of shale’s growth this year. While the U.S. market remains oversupplied, the international market is tighter, reflected in a $5 premium for Brent. With Brent now trading at the $55 area, it is not far from the February highs and it is near the Saudi goal of $60. The weaker WTI price, ironically, helps OPEC since it inhibits U.S. producers from selling forward their future production and locking in future production margins.
Brent in backwardation
Analysts have stated that one of OPEC’s goals, perhaps even more tactically important than rallying prices, is to move the futures curve from contango into backwardation, where near-term prices are higher than future prices. Presently, the Brent curve is flat to very modestly in backwardation, but even this development is sufficient for a modest victory.
When the futures curve is flat or slopes downward, i.e. “backwardation,” refiners have little financial incentive to build or hold inventory and crude stocks typically draw or remain at lower levels. This helps OPEC manage the market by discouraging inventory accumulation and by making it more difficult for producers, particularly U.S. producers, to sell production forward at higher values. OPEC can encourage backwardation, or manipulate the shape of the curve, by restricting sales in the front end of the market and selling more crude oil for deferred delivery.
U.S. inventory draws
OPEC’s cuts have targeted the U.S. market since data here is the most timely and transparent, and inventory declines have a more immediate effect on prices. Based on preliminary EIA data, Saudis Arabia has shipped 778,000 barrels per day (b/d) over the past month to the United States. This is approximately 37 percent lower than the same period last year. Since April, U.S. commercial crude stocks have fallen by 73 million barrels, or almost 15 percent, compared to a decline of 23 million barrels during the same time last year.
“OPEC’s chosen yardstick is the stock overhang above the five-year average. That’s shrinking steadily. From OPEC’s point-of-view, the cuts will succeed, eventually.”
Stocks have also fallen throughout the OECD. OPEC puts OECD commercial stock forward cover at 62.9 days, down from 63.9 at the end of May and much lower than the 65.3 days at this time last year. Forward cover is another sign that OPEC’s efforts to reduce production is rebalancing the market. “OPEC’s chosen yardstick is the stock overhang above the five-year average,” said Foreign Reports’ Reed. “That’s shrinking steadily. From OPEC’s point-of-view, the cuts will succeed, eventually.”
Global petroleum demand also has been increasing, and this helps absorb part of OPEC’s surplus production. Demand in India and China has unsurprisingly outperformed expectations and OECD demand has also been more robust than forecast due to strong economic growth that has increased gasoline and diesel demand. OPEC this week adjusted its total oil demand growth upward by 50,000 b/d for 2017 and by 70,000 b/d for next year. The IEA now sees global oil demand growth at 1.6 million barrels per day this year. The agency revised upward its figure by 200,000 b/d in the past two months.
Increased demand growth makes it easier for the market to keep the market in balance and further drain inventories. However, in order for the market to remain elevated, OPEC must also continue to adhere to their reduced quotas. “The fact that the OPEC/non-OPEC agreement, aided by strong demand growth, is proving to be quite effective, however, could also result in ebbing compliance or perhaps an inability to extend the cuts throughout 2018,” said JBC Energy analysts in a recent note. JBC’s estimates for 2017 now show a supply deficit of 240,000 b/d for the year.
When discussing the “success” surrounding OPEC’s cuts, it’s important to remember where the market was at the beginning of 2016, when WTI prices fell to $26. At that time, OPEC began talking about switching strategy from pumping all-out to freezing or curbing output to tighten fundamentals and increase prices. By the end of 2016, prices were double those levels and OPEC finalized its agreement to curtail production. Even though the market hasn’t reached $60, economic growth and increased inventory draws could boost prices to that level by next year—just in time for the Aramco IPO.
When discussing the “success” surrounding OPEC’s cuts, it’s important to remember where the market was at the beginning of 2016, when WTI prices fell to $26.
All of this is not to say that OPEC has brought stability to the market. Prices have been remarkably less volatile as of late, but if a surge of non-OPEC supply comes online, or OPEC members cheat on their quotas, or speculators sell all at once, the market could see another dramatic selloff. Alternatively, the market could overshoot at some point to the upside, thanks to OPEC restraining supply for too long, unplanned production outages, or stronger-than-expected economic growth. Then, analysts would have to quickly revise their price forecasts upward and revisit their thinking on OPEC’s market power.