Sunday, January 01, 2017

OPEC deal nothing more than a face-saving initiative

The following article of mine first appeared at Trend News Agency, on December 6, 2016

At its 171st official meeting on November 30, OPEC announced that it will reduce oil production by 1.2 mb/d to 32.5 mb/d from reference October levels, effective for 6  months, starting from January 1, 2017.

Not many people expected that OPEC would agree to bring its crude oil supply down to 32.5 million barrels per day (mb/d) from almost 33.8 the previous month. It was because negotiations were thought to be in deadlocked over the issue of who would cut by how much. Biggest surprise was Russia which changed its position from freeze to reduce output by 300 kb/d from the 11.2 mb/d it reached in October.

 Let us first put the significance or insignificance of the output cut into a perspective.

 This will be OPEC’s first output cut since 2008. The oil markets reacted sharply. In the three days following the announcement of the cut, Brent crude oil price registered more than 16% increase, or $10. Because of this, we have seen many people arguing that OPEC is not dead yet, OPEC empire strikes back, OPEC is still relevant etc. In my opinion this time the so-called "deal" was a certification that OPEC has a big mouth but no teeth, low prices are hitting the economies of its members and they cannot do much about it. Remember, just 2 years ago, OPEC had decided not to cut output. At that time Ali Al-Naimi, Al-Falih's predecessor, proclaimed it was not "in the interest of OPEC producers to cut their production, whatever the price is" and that it didn't matter whether oil prices went "down to $20, $40, $50, $60 a barrel -- it is irrelevant." We all know what happened to the economies of OPEC members in the past 2 years. OPEC press release for instance says that current market conditions "threatens the economies of producing countries". So, they had no option but cut production to help push the prices upwards. In May 2016, al-Naimi has been replaced by Khalid Al-Falih. The current OPEC agreement shows that Saudi Arabia is not any more a swing producer, and that OPEC does not have any more power, or at best struggles to balance world oil supply and demand.

 In Algiers meeting three months ago, OPEC ministers announced that they need to freeze daily output between 32.5 to 33 million barrels. Since then they have been working on the formulation of such a freeze and possibly a cut. It took a while because the intention was not to upset anyone. On November 30 meeting the OPEC announced that they agreed to cut daily production level from 33.7 to 32.5 million barrels per day, between January and June 2017. The best way for not upset anyone and hence come up with a reasonable agreement or face saving deal was to have proportionate cuts of 4,5% in members' output. Nigeria and Libya are exempted from the deal because they are still trying to recover from previous outages due to civil unrest and war. Angola's reference level was backdated to September 2016 in order to take account of scheduled maintenance which lowered output in October. Iran's reference level was backdated to pre-sanction period so that the country is in fact allowed to increase its output by 90 kb/d. Indonesia, currently a net oil importer, decided to suspend its OPEC membership. At the end only a few countries have pledged to cut output. At the end of the day, the deal is indeed a production freeze for some members, a cut for some others, and an increase for a few. We should keep also in mind that usually OPEC production in the first half of the year is lower than the second half.

Table: OPEC Crude oil production levels and adjustments

Production allocations agreed in Nov 2016
Production in Oct 2016 (OPEC MOMR)
Reference production level
Committed production from Jan-2017
S. Arabia
Notes:  Reference production levels are generally Oct 2016 from Secondary sources.
For Angola reference level is Sept 2016. Iran is given an enhanced reference production level.

 The "deal" is in fact nothing more than a face saving initiative because otherwise the production cuts, to take effect from January, are largely based on what the OPEC members were producing in October 2016, reference base to crude oil production adjustments. What is the point of selecting a reference month when OPEC output was at a record high? Some key non-OPEC countries are expected to the cut their production by 600 kb/d. Half of this amount is expected to come from Russia. Russia's oil production was also at the highest in October 2016 (since the Soviet-era peak). So, the possible Russian contribution to the OPEC deal is also not a real production cut. In fact we are likely to have production freezes, not real cuts. Where the remaining part of the cut will come from is unclear. Azerbaijan, Brazil, Mexico, Oman and Kazakhstan are names as potential candidates. Except for Kazakhstan the production in those countries were expected to decline anyway.

On 30 November 2016, the day when the OPEC meeting was held, the oil market was very volatile. Combined volumes in the ICE and CME crude oil contracts on that day hit all-time high on 30 November 2016. The total amount of crude traded on both exchanges (futures+options) was around 5.3 million contracts, equivalent to 54 times the daily world oil supply.

Market fundamentals and expectations of traders about the future are reflected in the prices in the paper barrel market, where many other factors also come into play. Seen from this perspective, the recent erratic oil price dynamics are indeed due to the weighted combination of expected market fundamentals and speculation, which, again, are affected by many factors. The main driver of market sentiment should be the facts, and not fears, concerns and worries of traders against perceived risks. But since the oil market is not transparent, free and efficient market, traders' expectations will continue to put additional pressure on prices.

 Look at the pathetic oil market data, especially monthly data, you will understand what I mean. World oil statistics are very far from perfect. Data on spare capacity, production, consumption and inventories are mostly estimates or best guesses, particularly for most of the non-OECD countries. Even OPEC doesn't believe what its members report to the Secretariat, which is why OPEC uses data from secondary sources to monitor the market, including production in its member countries. But where do those secondary sources get the data from is a question nobody asks. What an irony! In an environment where nobody can verify and prove the real production, cheating will prevail. This means the implementation of the deal in terms of self-compliance and the commitment to reduce production is vital for the "deal" to be successful. Production levels is said to be monitored by a committee of representatives from Kuwait, Venezuela and Algeria, plus two non-OPEC participants. I really wonder how they will monitor it. Cheating has been a common feature of the OPEC production cut decisions in the past. I don't see any reason why this tendency should change this time because of the concerns about losing or defending market shares of big producers particularly in Asia.

This brings us to another issue which is crucial for the oil market. The OPEC "deal" is supposed to remove 1,8 mb/d of oil from the market for 6 months - 1.2 mb/d from OPEC plus 0.6 mb/d from non-OPEC countries. Will we see a 1.8 mb/d cut? I don’t think so. In my opinion, OPEC will produce more oil next year than it produced this year. Besides, reducing production levels from an already high level won’t bring the oil market back into balance. But this is not too important either. In fact, the agreement, if succeeds, will remove that amount from the world oil production, not from the world oil trade. In other words, we should indeed be talking about the exports from the producer countries, rather than production. But it seems that nobody cares about that.

It is too early to forecasts how the OPEC deal will impact the global oil market. If this "deal" somehow achieves its intended aim it is highly likely that oil prices will rise, to $60 or above per barrel according to many observers. This could weaken demand growth in 2017, erasing the benefits of production cut. Moreover, price increase may accelerate the drawdown in stocks and tighten the supply/demand balance in the first half 2017. The problem is that crude inventory levels are above historical averages. This is why the question whether the inventory overhang can be brought down to historical range, and if yes, when, can still not be answered. Of course, if the OPEC deal is implemented successfully and important non-OPEC crude producers cooperate fully, we could see gradually eroding high inventories which would potentially move the market into “backwardation.” (Backwardation is a situation in which prices in the forward curve are lower than they are today; the normal state of the market, called “contango,” is when future prices are higher than today’s)

Higher prices will bring along two more crucial issues: the reactions of the Trump administration coming to power in the US in January, and the US shale oil industry which might be a big beneficiary of the OPEC deal. US crude oil supply expectations for 2017 change quite fast in relation to the price of oil. Current expectation is about 8.5 mb/d throughout 2017. In addition, shale oil production in Permian has so far been very resilient. Break-even price levels for majority of shale oil producers are estimated to range between $50-$70 per barrel. This means that cutting OPEC production and an increase in oil prices may have a double effect to open the door for shale oil producers as well as other non-OPEC producers to ramp up their output at the expense of those OPEC members who promised to cut production.

A tightening in the world oil balance will take time, surely more than 6 months what OPEC agreed for now. The production cuts are planned to last for six months. Then what? After six months OPEC will review the market fundamentals and decide at its next formal meeting on 23 May 2017 whether to extend its ill-fated policy. We can be sure that between December 2016 when OPEC plans to hold a meeting with non-OPEC countries and OPEC's next ministerial meeting on May 2017, there will be plenty of formal and informal meetings that will make oil prices a permanent item in global agenda in 2017. Whether the immediate upward push to oil prices following the OPEC meeting will be kept or lost is not easy to judge but optimism created for prices to stay well above $50 in 2017 might fade away faster than thought. The current Brent forward price curves do not show a long-term impact of OPEC deal on the oil market.



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