The Fuse

OPEC Sows Confusion in Global Oil Market With Its Production Cut

by Matt Piotrowski | April 27, 2017

OPEC members, according to JP Morgan, have increased revenues by $18 billion compared to what they would have earned without a cut—but they could pay a price for their short-sightedness given the instability that is in store for oil markets for the rest of this year, and beyond.

Despite constant chatter of rebalancing, OPEC has wreaked havoc on oil markets with its production cut. By attempting to lift prices through verbal intervention and manipulation of supply levels, the cartel has sowed confusion and fostered greater uncertainty for the second half of the year. Citi’s Ed Morse stated that OPEC “unbalanced” the market, while Adam Sieminski, the former head of the EIA, has warned of a “Decade of Disorder” for oil as a result of geopolitical unrest and underinvestment, a situation that the cartel will not be able to calm. OPEC members, according to JP Morgan, have increased revenues by $18 billion compared to what they would have earned without a cut—but they could pay a price for their short-sightedness given the instability that is in store for oil markets for the rest of this year, and beyond. In fact, oil prices are currently in a downtrend, with NYMEX WTI under $49, giving OPEC more motivation to talk up the market and follow through on its cuts when it meets next month in Vienna.

Below is a list of consequences from OPEC’s cut that market watchers have identified as factors spurring a volatile environment.

Before you cut, pump all out

Ahead of the implementation of the OPEC cut starting in January, OPEC members increased output and exports throughout the fourth quarter of last year. Buyers wanted more oil because of expectations for a tighter market in 2017 and OPEC producers wanted to increase revenues through higher volumes before having to throttle back. The extra oil in transit as a result of higher Q4 output led to big stock builds in the first quarter of this year while OPEC was touting its high compliance, creating a puzzling market dynamic.

OPECprod

Gaming the forward curve

Through its cuts, OPEC has sought to tighten the forward curve in order to take away incentive to store crude in order to incentivize inventory draws. It succeeded, but the move also backfired. Tighter spreads along the forward curve did emerge after the cut was put in place, but it also spurred the end of storage plays in a number of regions. As a result, a lot of extra oil was dumped onto the physical market. “Volumes released from storage, while hard to quantify, are large enough to be of significance for the wider market and will act as a buffer which will need to be cleared before the underlying tightening in supply-demand balances can become the market driver again,” analysts at JBC said in a note this week.

 U.S. hedging spree

The new wave of shale production has the potential to puncture prices, particularly if OPEC members cheat on their quotas.

Analysts warned that OPEC would likely target the U.S. market, where crude oil inventory data is more transparent than in other regions and draws have an outsized effect on prices. Through the first quarter, however, inventories kept rising, a consequence of the first two factors on this list. Crude stocks have fallen for three straight weeks, suggesting that OPEC’s cuts may be starting to bite in the world’s biggest consumer. There are two catches here, however. First, the decline in inventories may simply be following normal seasonal trends. Second, the cut and subsequent price rise have boosted hedging in U.S. shale, boosting domestic production beyond original expectations. This wave of production has the potential to puncture prices, particularly if OPEC members cheat on their quotas.

Speculators speculating on OPEC

The OPEC Secretary-General Mohammad bragged that after the cartel’s announcement of its cut, it was able to boost speculative length by more than 84 percent from late November to mid-February.

The OPEC cut, decided after months of talking about a cut, prompted hedge funds and other speculators to place bets on higher prices. An extraordinary amount of net length has been built up in the crude futures and options markets, meaning a sharp reversal could occur if they sell en masse should fundamentals fail to tighten. It’s clear that with OPEC having met with hedge funds late last year and in early 2017, the cartel seeks to gain their favor in order to get their help to push prices to levels producers want. This week, Secretary-General Mohammad Barkindo bragged that after the cartel’s announcement of its cut, it was able to boost speculative length by more than 84 percent from late November to mid-February. But OPEC can do this for only so long. Hedge fund sentiment is fickle. As Citi’s Morse noted, the investor buying created “the appearance” that the market had tightened, but prices were actually “in a froth.”

If you don’t sell to Asia, I will

The OPEC cut has upended global trade flows. Asia is clearly the hottest market, with growth expected to continue there for decades. As OPEC has curbed production, both U.S. and North Sea sellers have muscled their ways into the Asia-Pacific region as buyers there shopped around to make up for barrels that got cut. Bloomberg reported that traders have sent at least 42 million barrels of oil from the North Sea to Asia, more than double year-ago levels. From November through January, the U.S. shipped 68,000 barrels per day to China, based on final EIA data, though volumes might have risen in the past few months as OPEC has stuck with its strategy.

What happens when OPEC lifts the deal?

Another price collapse, while a boon for consumers, would add to long-term investment cancellations and deferrals, further increasing chances of a shortage and price spike later on.

If OPEC doesn’t cut at its next meeting a month from now, oil prices would crash into the low $40s. If OPEC does extend its production curbs, the elevated price will likely prompt more hedging in the U.S. and support investors to go long once again. This combination has the chance to eventually bring about a massive correction. Even if that doesn’t come to pass, what happens when OPEC eventually lifts the deal, perhaps later this year or in 2018? That would instantly add 1.2 mbd of OPEC crude alongside extra volumes from non-OPEC participants, meaning almost 2 mbd could flood the market at the same time. That, of course, would bring another leg down for oil prices, all things considered. This scenario, while a boon for consumers, would add to long-term investment cancellations and deferrals, further increasing chances of a shortage and price spike later on.

 

 

 

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