Part 5: The Key To An OPEC Agreement Is How Long Do The Cuts Last?
We started this blog series “Countdown To OPEC’s Nov 30 Meeting” at the beginning of Nov because we expected to see chatter and chatter impacting oil prices. Up until last week, the oil tone was weak and in line with our expectations for weak oil prices until any last minute deal or clearer indications that the major parties (ie. Iran, Iraq, Saudi Arabia) are moving to a deal. Plus we expected that the prior track record of OPEC quota cuts suggested a deal shouldn’t be expected until the last minute.
However, the tone turned positive on Saturday night and was primarily driven by Shana’s Sat Nov 19 story “OPEC Highly Probable to Reach Accord on Freeze Plan: Iran”. [LINK] The opening line of the Shana story was clear – “Iranian Minister of Petroleum Bijan Zangeneh said: “It is highly probable that oil and energy ministers of the member countries of Organization of Petroleum Exporting Countries (OPEC) will reach an agreement [on production freeze plan] in the November 30 meeting.” It was important that the story came from Shana, the news agency for Iran’s oil ministry. That positive tone has continued with reports from OPEC’s High Level Committee in Vienna on Mon/Tues that OPEC members are reaching an agreement to hit the lower end of the Algiers target cut of 32.5 to 33.0 million b/d.
We continue to be in the camp expecting an OPEC agreement on Nov 30. However, assuming OPEC can do so, we wanted to highlight the key factor to watch that will determine the impact on oil prices – How long will the OPEC cuts last?
There was no time frame stated in OPEC’s Algiers Sept 28 deal announcement. OPEC said “the Conference opted for an OPEC-14 production target ranging between 32.5 and 33.0 mb/d, in order to accelerate the ongoing drawdown of the stock overhang and bring the rebalancing forward.” Assuming no cheating (no laughing please!), we used the IEA’s Oil Market Report (OMR) Oct 2016 to create the below table to show the impact of an OPEC cut to 32.5 million b/d on the OECD oil inventory surplus. It is important to note that the IEA”s oil demand forecast is significantly higher in H2/17 than in H1/17. This is normal as oil demand is always up seasonally in H2 of every year compared to H1.
- The OECD oil inventory overhang problem is 145 million barrels YoY and 348 million barrels vs 5 yr average as per the IEA’s Oil Market Report (OMR) for Oct 2016. We believe markets are looking for visibility to at least eliminate the YoY surplus for a move to $60 oil.
- Oil prices are going back below $40 without an OPEC cut. Oil demand is seasonally lower in H1 than H2 in all years. As noted in the above table, no change to OPEC oil production would add ~100 million barrels to an already huge OECD global oil inventory overhang.
- A 6 month deal would eliminate 127 million barrels or 88% of the YoY surplus oil inventory overhang in 2017. We think the OPEC deal is likely to have an initial 6 month time frame. OPEC would believe they can fix most of the inventory overhang in H1/17, and then let the normally increasing seasonal oil demand in H2 fix the rest of the overhang over the next 6 to 9 months. Based on the IEA’s OMR, a cut to 32.5 million b/d for H1/17 and a return in H2/17 to Sept 2016 OPEC oil production levels would eliminate, by year end 2017, 127 million barrels or 88% of the 145 million barrels YoY surplus. Plus oil prices should be firmer, but not high enough to bring back marginal high cost barrels – what OPEC has spent the last two years trying to stop.
- A 12 month deal would eliminate 329 million barrels or 95% of the 5 yr surplus inventory overhang in 2017. We don’t see this as being the likely time frame. It would provide a very bullish H2/17 outlook for oil and one that OPEC could see bringing back some of the marginal high cost barrels. Plus we doubt that they believe they could hold discipline on a quota for 12 months. A 12 month deal would eliminate 329 million barrels or 95% of the 5 yr surplus inventory overhang of 348 million barrels.
- There are a number of caveats on these numbers. They assume OPEC agrees to the bottom end of their 32.5 to 33.0 million b/d range and there is no OPEC cheating above the 32.5 million b/d. The IEA OMR is probably more of a market mover than the EIA’s Short Term Energy Outlook, or OPEC Monthly Oil Market Report, but the IEA is more bullish on oil demand so using the EIA STEO would have less of the inventory overhang eliminated. They don’t assume any incremental supply response from the US.
- The oil price response will likely follow a similar pattern to what was seen in Henry Hub gas prices this spring. There was a massive 1 tcf YoY storage surplus at April 1 moving into the low demand spring shoulder season. Even still, the April 1 tcf YoY storage surplus was slowly but steadily reduced in the shoulder season leading to modest strengthening in natural gas prices. But as the higher summer natural gas demand kicked in and there was the visibility that the 1 tcf YoY storage surplus could be eliminated by winter, natural gas prices strengthened to $3. The oil response should be similar. Based on IEA’s forecast, we should see steady modest declines in YoY oil inventory surplus during H1 to move oil prices modestly stronger. Even though H1 is a lower demand period for oil, an OPEC cut to 32.5 million b/d should reduce the global oil inventory YoY surplus by 63 million barrels in Q1 and 36 million barrels in Q2. If these Q1 and Q2 declines can be achieved, markets will see the potential for the YoY inventory surplus to be gone (or mostly gone) in H2/17, and this should lead to further strengthening of oil prices in H2/17. The strength of the H2/17 price increase to be dependent upon how long the OPEC cuts last.
Assuming OPEC can get to the 32.5 million b/d cut, the focus should be on how long the OPEC cuts will last. An OPEC cut to 32.5 million b/d will provide a higher floor price (ie. ~$45 not <$40) to oil going into the lower H1 demand period and support for a trading range around the current ~$48. The key will be how long the OPEC cuts last? We see a 6 month deal leading to oil prices in the mid $50’s moving into year-end 2017, whereas a 12 month deal leading to oil prices well above $60 before year-end 2017.