A Second Look At The OPEC Deal: Here's What Can Go Wrong
Defying numerous skeptics, today’s historic OPEC decision to cut production, a first since 2009, marks a clear turning point in cartel, and especially Saudi Arabian, politics: individual country quotas have been allocated to all members, a third-party production verification process has been established, and the world’s largest crude oil producer Russia has committed to freeze production.At least, that’s what the deal looks like on paper.
For those who missed today’s fireworks, which saw oil soar as much as 10%, here are the key details.
The OPEC deal features explicit country level production adjustments that target a reduction in OPEC crude production to 32.7 mb/d, down 1.2 mb/d from October (as measured from secondary sources). Libya, Nigeria and Indonesia (an oil importer) are exempt from any adjustment and apart from Iran, the remaining country production decline is 4.6% vs. October (September for Angola). Iran’s participation, while essential to this deal, still leaves questions unanswered with the agreement allowing for a 90 kb/d increase in production when compared to October OPEC secondary sources, but requiring a 180 kb/d cut from October production when measured through direct communication. While no details were provided, non-OPEC countries are expected to join this deal with a target of reducing supply by 0.6 mb/d and Russia expected to commit to a 0.3 mb/d production cut. While Russia embraced the deal, it made it clear it would be very slow in cutting production due to “technical issues”, and refused to explain from what level it would make the 0.3mb/d cut – Russia previously suggested it may cut from a projected budget output level for 2017, suggesting Russia won’t actually cut production at all.
OPEC and Russia have agreed to cut production to 32.5 mb/d and 0.3 mb/d respectively
The ultimate goal of the OPEC production cut is to normalize excess inventory levels but not to target outright high prices, as that would prompt a surge of shale production. As the Nigerian oil minister Kachikwu admitted in Vienna today, OPEC sees $60/bbl as the “perfect” price for oil as at this price “it would not bring too much shale oil.” As Goldman further explains, normalization of inventories is key to low-cost producers as: (1) it generates backwardation which removes hedging gains from high-cost producers and helps low-cost producers grow market share, and (2) it reduces oil price volatility which increases the valuation of the debt and equity they are issuing. In our view, the goal of normalizing inventories should however not target elevated oil prices as the flattening of the oil cost curve and the unprecedented velocity of the shale supply response would likely make such an endeavor rapidly self-defeating above $55/bbl. This is consistent with today’s OPEC press conference and official statement which focused on rebalancing the oil market and explicitly mentioned excess inventories, but not higher prices.
In other words, OPEC is hoping for higher prices, but not too high: anything above $55 defeats the purpose of today’s deal. This is the first risk, because should the latent short interest in the future trading community continue its panicked covering, there is a distinct possibility oil may spike above $55 merely on technicals, precipitating a much faster than expected arrival of shale oil. To be sure, US production has been rising for 6 of the past 7 weeks as is, however a spike in price will accelerate it notably.
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Another key risk to emerge to the deal, as revealed in a statement issued moments ago by Mexican oil company Pemex, which according to Bloomberg said it isn’t planning further output cuts in 2017, in stark refutation of a comment by the abovementioned Nigerian oil minister that Mexico would cut production by 150k b/d after the OPEC deal. Earlier in the day, Nigerian Minister of State for Petroleum Resources Emmanuel Ibe Kachikwu told reporters in Vienna that Mexico is expected to reduce by 150k b/d, however this is clearly not the case. This suggests that OPEC has been parading non-OPEC production cuts without any actual verification, and since the Russian production cut will likely be mostly a myth, there is risk that the follow up meeting in Doha next week could be a material disappointment in which OPEC and non-OPEC nations (which now include Indonesia) fail to reach an agreement.
There is further risk of non-OPEC compliance. While Russia is expected to cut production by 0.3 mb/d production, Russia’s track record in participating in OPEC production cuts is mixed. It complied well in 1998 to the two proposed cuts but instead increased production in April 1999 and January 2002. As a result, Goldman’s base case remains that Russian crude oil production will be flat.
Other non-OPEC participants likely include Oman, which has stated that it would match the OPEC cut (implying a 46 kb/d cut). Other past participants to non-OPEC cuts include Mexico, which we now know will not participate, and Norway which has also stated that it would not participate this time. Kazakhstan could be another contributor although it is currently expected to increase production by 140 kb/d. As a result Goldman says that it views details on this non-OPEC 0.6 mb/d additional cut as necessary for prices to meaningfully rally from here.
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Further jeopardising the deal is actual implementation. With the deal agreed to in principle and country level quotas established, focus will now shift to implementation. As Goldman explains, the deal is effective as of January and it will take three weeks of shipping data to get a sense of how well the deal is implemented, suggesting that the full upside to oil prices will likely only materialize by late January.
Looking at the last 17 production cuts (1982-2009), observed production cuts have typically come in at 60% of the announced cuts, as measured by the change in secondary source production vs. the decline announced as calculated by the difference between pre-cut production levels and the announced quota levels. Assuming the historical 60% compliance by OPEC members means the cut declines to just over 700,000 barrels from what are already record production levels.
The key to the remaining upside in oil prices will be determined by the compliance to the announced quotas
Historically, observed production cuts have fallen short of initial targets
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Another risk emerges not on the supply but demand side. As Bank of America writes, we continue to expect annual global oil demand growth to average 1.2 mn b/d, but we are concerned about higher US interest rates and a disorderly CNY depreciation. BofA also points out what we noted above, namely that it is also possible that non-OPEC ex Russian crude oil production recovers faster than we are currently expecting. Whether it is easier regulations in the US or continued production efficiency gains, it is worth keeping in mind that technology is at the heart of this oil price war. Despite the deal that OPEC just agreed to, technological advances will keep the members of this unlikely alliance on their toes. As a reminder, Goldman expects healthy US production growth at $55/bbl.
Goldman’s scenarios for US oil production under various annual oil prices (5% lower reinvestment rate at $45/bbl
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In sum, OPEC has so far managed to fool the market, and send the price of oil surging off all time lows hit in early 2016 even as OPEC output has reached record highs, and the just concluded deal may end up eliminating just a small fraction of this excess supply. There is also risk that demand – most notably out of China – will continue to decline, delaying the so-called market equilibrium even assuming full OPEC and non-OPEC compliance. And, courtesy of Modi’s ridiculous “demonetization” attempt, India’s economic outlook is suddenly in jeopardy: should Indian oil import demand decline as a result, OPEC will have to double its daily production cuts just to catch up to the drop in global demand.
In any case, it will take at least 3-4 months – some time in February – before the world has a sense of how OPEC is implementing and supervising its own production cuts, even as non-compliant non-OPEC members, especially shale, scramble to steal OPEC’s market share. Perhaps the best forecast at this point is that the price of oil will remain rangebound between $45 and $55. Below that and more jawboning will emerge; above it and concerns about shale output will dominate.
Finally, it is safe to say that this is OPEC’s final attempt to prove it is still relevant in a shale-driven world after the “2014 Thanksgiving massacre” when Saudi Arabia essentially unilaterally crushed the organization, and the price of oil. Should OPEC blow this, it will likely be game over for any future attempts to artificially prop up the oil price by the world’s oil exporters.