Part 6: Deal Or No Deal, What Is The Impact To The Current Oil Oversupply?
Oil closed down $1.85 today to close at $45.23 as the market moved mostly into the camp of no deal believing that the major players (Saudi Arabia, Iran, Iraq and Russia) are not going to close the gap and reach a deal. If anything, the reports suggest the gap could be widening. We are writing this blog as of 7:30pm mountain time.
We started this blog series “Countdown To OPEC’s Nov 30 Meeting” at the beginning of Nov because we expected to see a month of chatter, oil price volatility, and knowing that the track record of OPEC quota cuts suggested a deal shouldn’t be expected until the last minute. This provided an excellent window in Nov to write our blog series.
It is now the early hours of Nov 30 morning in Vienna, decision day for OPEC ministers to figure out “deal or no deal”.
The ‘no deal” scenario impact is clear at least for the near term. No deal means that the current global oil oversupply gets worse in Q1 and Q2 and this should send prices lower right away. Today, the momentum moved to no deal with many believing that Saudi Arabia is not bluffing and will do, like they did at Doha in the spring, walk away if the others (Iran, Iraq, and Russia) don’t join in on making reasonable cuts.
The potential certainly seems less tonight for a deal tomorrow. However, we have been in the camp that an “agreement” of some sort is achievable as we see a key difference since Doha – Iran’s relative negotiating position is stronger today and only getting stronger in the future. Our Nov 14 blog “Part 3: Better To Deal With Iran Now Before They Get Even Stronger” [LINK] noted the lifting of sanctions was a game changer and gives Iran negotiating leverage over everyone else in OPEC. It provided a return of capital of ~$50 to $100 billion and allowed Iran to ramp up oil exports. Our Nov 14 blog concluded “Even with the negatives, it may well be the best possible time for Saudi Arabia to grit their teeth and accommodate Iran. Iran is expected to only get stronger economically.”
The only thing clear about a “deal” is that it will be discounted to some degree with the expectations of cheating.
The impact on oil prices for a deal will depend on the key deal terms, including (i) The OPEC target quota amount. The Algiers agreement said a target of 32.5 to 33.0 million b/d. (ii) The per OPEC country quota amounts. Markets will discount any OPEC quota that doesn’t have specific by country quotas. (iii) The term of the deal will determine the volume of oil taken off the market. We expect the likely term will be 6 months. Our Nov 22 blog “Part 5: The Key To An OPEC Agreement Is How Long Do The Cuts Last?” [LINK] highlighted the importance of term of deal. (iv) The starting OPEC production levels by country could impact the perceived level of cheating. Our Nov 7 blog “Part 2: Increasing Challenge To Get Down To 32.5 Mmb/d” [LINK] highlighted the differences between OPEC’s reported oil production by country based on “direct communications” from the OPEC members vs “secondary sources”. The secondary sources numbers were implied as the starting point to get to the Algiers 32.5 to 33.0 million b/d. (iv) Non-OPEC cuts. Its not part of OPEC, but markets will be looking to non-OPEC producers, in particular Russia for some support to any OPEC deal.
The impact on oil prices will be determined based on how a deal or no deal will improve or worsen the current global oil oversupply. As of Sept 30, OECD global oil inventories were 113.8 million barrels up YoY, and over 300 million barrels up vs the 5 year average. We believe markets are looking for visibility to eliminate the YoY surplus to return oil to over $50. The key assumptions to the below table are: (i) Estimated demand, non-OPEC supply and OPEC NGLs from IEA’s Oil Market Report Nov 2016. (ii) OPEC’s Oct oil production from OPEC’s Monthly Oil Market Report Nov 2016 for “secondary sources”. (iii) Sept 30, 2016 OECD crude oil inventory from IEA’s Oil Market Report Nov 2016. (iv) We do not assume any non-OPEC cuts.
- Our Nov 22 blog included a similar analysis using IEA’s OMR Oct 2016. The OMR Nov 2016 had minor changes in its 2017 forecast, but these changes reduced the net overall Q1 demand for oil by 0.3 million b/d or 27 million barrels over the quarter.
- The YoY OECD crude oil inventory surplus is 113.8 million barrels as of Sept 30.
- No deal means that YoY OECD crude oil inventory surplus widens to 176.8 million barrels in Q1/17, and to 240.5 million barrels in Q2/17. We don’t see the math supporting Saudi Arabia’s view that oversupply is corrected in H2/17 in the no deal scenario. The normal increasing seasonal oil demand in H2 (vs H1) means the oil oversupply gets slightly better in H2/17. But for 2017 in total, the YoY OECD crude oil inventory surplus of 113.8 million barrels goes up by 99.1 million barrels to reach 212.9 million barrels.
- A 6 month OPEC deal at 32.5 million b/d reduces the 113.8 million barrels surplus by 72.4 million barrels in H1/17 to 41.4 million barrels surplus. If OPEC returns to Oct 2016 production levels of 33.6 million b/d in H2/17, it will further reduce the surplus by 27.6 million barrels. For 2017 in total, the surplus would be reduced to 13.8 million barrels or 88% eliminated with visibility to be gone in Q1/18.
The immediate market reaction will focus on deal or no deal. But, where oil prices settle out in the short term and where they can reach in 2017 will be determined by how a deal or no deal changes the current global oil oversupply. A no deal leads to a worsening H1/17 oil oversupply, should send oil prices below $40, and likely not returning to current levels until there is clear visibility that the oversupply is starting to be consistently eliminated ie. late in 2017. An OPEC cut to 32.5 million for 6 months provides visibility that the YoY oil oversupply gets mostly fixed in H1/17 and 88% fixed by year end 2017, which should provide a higher near term floor price (ie. ~$45 not <$40), support for a trading range around $50, and oil prices in the mid $50’s prior to year-end 2017. A 12 month OPEC cut to 32.5 million b/d seems unrealistic, but should see oil prices well above $60 before year-end 2017.