Another Band-Aid for Nine Months?

In Vienna yesterday, OPEC announced that it would be rolling over the landmark supply freeze that began in January 2017 by another nine months. Joining them will be the key non-OPEC members — principally Russia, but other major Central Asian producers — extending the 1.8 mmb/d cuts (1.2 mmb/d for OPEC and 600 kb/d for non-OPEC) through to March 2018. Ordinarily this would be cause for cheer. But instead, the markets reacted in dismay. Brent and WTI plunged by almost 5%, erasing all gains from the last week.

It is an overreaction, certainly, but also evident that the market was expecting a more drastic cut from OPEC to help bolster prices. The extension of the freeze is good, but had already been telegraphed weeks ago by rumblings out of Russia and Saudi Arabia. So that has already been factored into the price — one of the reasons why crude rose over the past week — and traders were looking for a little bit more good news, deeper cuts. When that did not materialise, the sell-off happened.

What’s going on? It took no rocket scientist to predict back in January that the OPEC freeze effect would be blunted by rising production elsewhere. Despite record compliance within the OPEC block — even Iran and Iraq toed the line — once the supply cuts took place, crude from elsewhere rushed to take its place. We saw crude from Alaska shipped to China for the first time, while Japan and South Korea offset Saudi Arabia’s cuts to their supply with crude from West Africa. Buoyed by price signals, American production from onshore shale deposits surged. Two weeks, the American oil rig count blasted past 700 active rigs, the highest in almost two years and is now marching towards 800. This rise in American production is estimated to have offset at least two-thirds of the lost OPEC output. And at current trends, it is estimated that some additional 900 kb/d of oil from the US will be added to global production. Nelson Martinez, Venezuela’s oil minister said “In terms of the threat, we still don’t know how much (U.S. shale) will be producing in the near future” after the recent OPEC talks. The Energy Minister if UAE, Suhail bin Mohammed al-Mazroui commented that he personally did not believe U.S. oil production would rise by 1 million bpd by next year. Representatives from US Shale who attended the Vienna meeting did not provide any specific guidance or projections either, keeping plans close to their chest.

So analysts were hoping that OPEC would match that with another cut. But getting OPEC to agree on additional cuts is like herding cats. The original November 2016 was landmark, and the high compliance another rare occurrence. But despite this, global inventories and supplies remain high. Part of this is artificial; in the six weeks between announcement and implementation, OPEC members pumped record volumes of crude, stockpiling them to sell during the freeze period. This is evident when you look at OPEC export statistics; they have fallen, but not nearly by as much as production. Extending the freeze may do the trick, to account for this lag. Saudi Arabia certainly seems to agree, pointing out that US crude supplies may have risen over the early period of the freeze, but had fallen for the past seven weeks, which helped convince some OPEC members of the delayed impact. The second half of the year is also a more strategic time to see the impact of the cuts, when the Middle East nations hoard crude to burn for summer power requirements and American/European drivers go out for summer, driving gasoline demand.

But still, there are issues. Libya and Nigeria were exempt for the original OPEC freeze. Their production has been rising following quelling of insurgent activity, while OPEC welcomed its 14th members, Equatorial Guinea, which replaces Indonesia that left last year. The wording of the OPEC announcement suggest that all three will not be expected to produce within the existing quotas, potentially blunting the impact further. Gone are the days when an OPEC freeze was a standalone solution.

Now is this merely a band-aid, kicking the ball further down the road to March 2018 where OPEC will once again have to ask themselves or do we need more cuts earlier? OPEC meets again in November to reconsider output its policy. Reuters reports that “while most in the group now appear to believe that shale has to be accommodated, there are still those in OPEC who think another fight is around the corner”. Nigerian Oil Minister Emmanuel Kachikwu commented that “If we get to a point where we feel frustrated by a deliberate action of shale producers to just sabotage the market, OPEC will sit down again and look at what process it is we need to do”.

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