The Fuse

OPEC’s Decision to Lead to More Volatility: IEA’s Birol

by Leslie Hayward and Matt Piotrowski | December 06, 2016

Last week’s groundbreaking OPEC meeting was notable for many reasons. Not only was it the cartel’s first coordinated output cut in eight years, it also involved agreements from major non-OPEC producers. The deal will trim nearly 2 million barrels per day of supply from the market, while also reinstate individual country production quotas. Crucially, the agreement came together with cooperation from Russian President Vladimir Putin, Saudi Deputy Crown Prince Mohammed bin Salman, and Iranian Supreme Leader Ayatollah Ali Khamenei. According to Reuters, Putin and Salman met on the sidelines of a G20 meeting in September in China and agreed to collaborate to help rebalance the oil market.

Saudi Arabia’s last-minute assertions before the meeting that it was willing to leave Vienna without a deal pulled Russia into the fray—with Putin ultimately brokering an agreement between the Saudis and Iranians when the latter continued to refuse to cut production. Insiders report that the Russian leader established that the Saudis would shoulder the lion’s share of cuts, as long as Iran would agree not to publicly celebrate victory over the Saudis. Russia also agreed on the same day as the OPEC meeting to trim 300,000 barrels per day of its own production, providing half of the 600,000 b/d needed from non-OPEC producers to seal the deal.

Another unusual detail of the deal emerged in the Financial Times, which reports that OPEC consulted oil traders the day before the meeting to understand the price implications of various outcomes.

Another unusual detail of the deal emerged yesterday in the Financial Times, which reports that OPEC consulted oil traders the day before the meeting to understand the price implications of various outcomes. Leading representatives of trading giant Vitol, the $1.5 billion oil hedging firm Andurand Capital, and the trading arm of Russian oil producer Lukoil met with the Saudi Delegation before Energy Minister Khalid al-Falih arrived in Vienna. None of the traders agreed to comment on the details of the session, but the FT says that such meetings between Saudi Arabia and major trading houses are rare, although not entirely untoward.

The intense levels of collusion on a global scale between politicians, OPEC representatives, and even traders are a clear reminder that the cartel’s operations undermine a fair, free, and transparent oil market.

The intense levels of collusion on a global scale between politicians, OPEC representatives, and even traders are a clear reminder that the cartel’s operations undermine a fair, free, and transparent oil market. OPEC argues that its decision last week was in the interests of price stability, but IEA director Fatih Birol sees the exact opposite. He told reporters that oil at $60 per barrel will reawaken U.S. shale, which will ultimately boost supply faster than demand and put downward pressure back on oil prices. “This volatility may be with us for some time,” Birol said. “We are entering a period of greater oil price volatility.”

jawboning

Will the cuts materialize?

Of course, others have expressed doubt that the deal will materialize in future supply data.

Even one of the most notable OPEC ministers of all time is skeptical. “We tend to cheat,” former Saudi Oil Minister Ali Al-Naimi said last week while speaking at the Center for Strategic and International Studies (CSIS), referring to OPEC countries producing above the agreed quotas after past deals. Ever since the cartel began constraining output decades ago to serve its economic and political purposes, members have overproduced, preferring to sell more volumes and boost revenues, sometimes by large amounts, instead of cutting back, causing a deep sense of suspicion and distrust. This lack of trust over the decades spurred Saudi Arabia, in November 2014, to keep production high as other members wanted the Kingdom to cut while they continued to pump at will, Naimi pointed out last week. It will be hard this time, too, to get countries to cut: After all, as a group, OPEC produced a massive 34.2 mbd in November, a new record and a reflection of members competing with each other for market share.

Countries within the cartel will see their production figures come under extra scrutiny starting in February, when January data will be published. Outside of OPEC, producers that agree to implement a cut may come under even more suspicion than those inside the cartel, given their poor track records of curbing output. Naimi was highly skeptical of the commitment from Russia, the largest non-OPEC country that is set to go along with the 13-member bloc, saying: “Will Russia cut 300,000? I don’t know. In the past, they didn’t.”

“The OPEC production cuts primarily support the front end of the curve. A supply/demand deficit is still only projected for the second half of 2017, and that by 2018 we may also be seeing more pronounced growth in U.S. shale oil production.”

While timely production numbers of committed countries will be key data points showing how effective the cut will be, the shape of the forward curve and inventory levels will also give indications whether the deal is working to the cartel’s benefit. Since oil prices started rallying sharply last Wednesday, the futures curves on both ICE and NYMEX have tightened. The narrower curves are mostly the result of speculators bidding up the front months in anticipation of higher prices, while producers have been selling contracts further out to lock in hedges. This suggests that the market could tighten over the short term, but the higher price will stimulate more production over time, particularly in U.S. shale. “The OPEC production cuts primarily support the front end of the curve,” wrote Tim Evans of Citi Futures in a note to clients. “A supply/demand deficit is still only projected for the second half of 2017, and that by 2018 we may also be seeing more pronounced growth in U.S. shale oil production.”

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Even so, a tighter forward curve takes away the financial incentive to build crude in inventories. If OPEC is successful in keeping the forward curve relatively flat the global surplus in storage could slim down—a major objective of the cartel since massive inventory volumes have helped keep a cap on prices. It will, however, take a long time for OPEC to remove the excess amounts stored in crude tanks—according to OPEC’s own data, OECD commercial stocks for crude and products stood above 3 billion barrels at the end of the third quarter, some 10 percent above the five-year average.

In a sense, the cartel has already succeeded. The conversation of an OPEC freeze, which began in early 2016 and evolved into a cut, has lasted for most of this year, helping to more than double oil prices.

How successful OPEC will ultimately be depends on a number of market factors, all of which are uncertain at this moment. But what is clear—in a sense, the cartel has already succeeded. In February, the oil markets dipped into the $20s, and a number of pundits had forecast prices to fall even lower. At that time, OPEC members started talking about freezing production. The conversation of the freeze, which evolved into a cut later in the year, has lasted for most of this year, helping to more than double oil prices. Longer term, the deal could backfire, but for now, OPEC’s jawboning has succeeded in helping give the market a huge shift in sentiment.

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