Special Issue: OPEC and the taming of the skew

Source: ECN

2017/08/24

ImageBROKER/REX/Shutterstock

ImageBROKER/REX/Shutterstock

Crude futures markets have begun to take bullish cues on the most flimsy signals

OPEC members and their non-OPEC allies have shown a high degree of cohesiveness in implementing oil production cuts since the Vienna agreement in late November 2016, and a relative degree of success. Yet, into the second iteration of supply cuts, their efforts to reduce global crude inventories and redress the downward skew of global oil prices is proving less effectual. This conjures up an interesting interpretation of the nature of OPEC as a so-called clumsy cartel. The management of oil prices by a group that cannot accurately predict market demand or production and that does not know how much obedience to expect from its own members is inevitably clumsy and inconclusive.

As a result, such inaccuracy leads to price movements that are not only unpredictable but often sudden and jarring. Along with increased US oil output, the unexpected rebound of Libyan and Nigerian production will slow the recovery, regardless of the overall high compliance rates elsewhere.

The current supply outlook is somewhat similar to 2004 when the price loss was attributed to OPEC’s loss of excess capacity. It is, hence, no surprise that criticisms have flourished on the low tide of crude oil prices, questioning OPEC’s unwillingness to deepen the cuts, and prompting the most steadfast analysts – among which Goldman Sachs – to revise their price forecasts from $55-60/bbl to $47.50–$51.00/bbl. Crude futures are now struggling to lift themselves above $50/bbl as markets slowly acknowledge the dead-cat bounce – a short recovery in share prices following a steep decline – of oil prices. Commerzbank analyst Barbara Lambrecht said in a 30 June research note: “Prices could fall even more in the short term, because the market might put OPEC discipline and the pain threshold of the US shale oil industry to the test.”

Nevertheless, markets have begun to take bullish cues on the most flimsy signals, among which was the first drop in US shale output since January. US crude oil output in April was 190,000 bbl below the Energy Information Administration (EIA) forecast, and down 100,000 bbl week on week as of 30 June. Although the bulk of it was due to special circumstances, markets immediately endorsed the “good news”, however temporary. During the same week, US gasoline stocks declined by 894,000 bbl, signalling that the summer driving season had kicked off. Seasonal effects are expected to dent global crude inventories and will help the market rebalance, as traders will not be able to ignore the resulting depletion.

US PUTS THE LAST BARRL TO THE TABLE

There is also hope that OPEC supply disruptions will mitigate the risk of oversupply by forcing some production out of the market. So far, US drillers have consistently undercut OPEC’s efforts to reduce the global supply glut, boosting production on stronger capital discipline and improved cost structure. They can now produce lower-cost barrels at a profit in the most prolific US plays.

Whether the US has become the new swing producer is a subject open to discussion, but it has undoubtedly become the marginal producer, putting the last barrel to the table, hence setting the global price. Besides, Saudi Arabia and other Gulf low-cost producers used to put their cheap barrels at the front of the cost curve, where the most efficient US producers are now capable to compete in a world where global oil prices are capped at $50/bbl or less.

A THIN LINE TO WALK

The low oil price is a delicate balance, not only for US drillers but also for other OPEC and non-OPEC producers. In a 28 June televised interview, Continental Resources CEO Harold Hamm warned that prices below $50/bbl were unsustainable and that drillers would be driven out of business if they fell below $40/bbl.

The good news is that US drilling may taper off and output growth halts to tighten capital outlays. The bad news is that at a sub-$50 level, the market is going to test the price resilience. Russia – the largest non-OPEC oil producer and exporter – is sticking to $40/bbl to plan its budget for the next three years.

Globally investors have significantly reduced their long hedging positions in Brent futures and covered their short positions instead, some of them increasingly betting on lower prices. Meanwhile, a lot of debt is building up in the hands of US oil exploration and production companies that, once again, borrow more than they should, in particular because of the US Federal Reserve’s stance on low interest rates.

Oil

Oil

As a result, significant amounts of capital are being diverted away from long-term investments that will be key to the secure supply of oil over the next twenty years. Combined with the resurgence of hard geopolitical realities, the risk of physical disruptions is still strong enough to put prices back on a bullish track. As Saudi Arabia’s minister of energy Khalid al-Falih underlined in June 2016, OPEC can deal with short-term, transient headwinds rather well, although not so much with structural imbalances.

On the upside, the threat posed by US shale oil may entice OPEC to sustain cuts long enough to boost oil prices, but also long enough to let US oil costs inflate to the point of driving US drillers out of the market, at least the less efficient ones, in turn helping to restore a global balance.

OPEC’s efforts have been hindered by the rapid decline of hydraulic fracturing costs in North America, but those costs may also respond just as quick to a price increase and stop the US recovery in its tracks.

The next moves by Saudi Arabia and its Gulf partners will be key to maintain compliance and production discipline in the coming months, especially as the temptation to relax quotas might be greater with the demand spikes over the second half of the year. In the end, the oil market rebalance may reach the proverbial “goldilocks pricing” – that is, a price that is neither too high nor too low but equally determined by the sell and buy signals.

Julien MathonniereJulien Mathonniere, is a market reporter covering crude oil in the ICIS Energy group. A trained petroleum economist from the University of Aberdeen (UK) with a strong background in journalism, he crunches numbers, runs models and draws curves to bring complex energy-related topics into shape, find hard evidence, and prop up sound market analysis. Julien covers various regions for ICIS, including Asia-Pacific, Arab Gulf, CIS, Mediterranean, west Africa, and North Sea. He is involved in the assessment of the French spot gas market and contributes French gas translations for ICIS. He also occasionally writes for the Financial Times on crude oil and related topics.