- OPEC surprises world with statement of intent to ‘cut’ production…
- …but plenty of traps and pitfalls remain, so this agreement is by no means a done deal
- Deal or no deal, the oil market is irrevocably gravitating towards equilibrium, leading to higher prices
OPEC surprises…yet again
In late September, the OPEC members met at an informal gathering in Algiers (Algeria) to discuss their options for guiding the oil market towards a better balance between demand and supply. Owing to years of oversupply, the oil price remains at an extremely low level. All oil producers are eager to see the oil price gain upward traction. In their statement of intent, the 14 members set out their intention to reach an agreement at their official meeting in late November in order to limit OPEC oil output to between 32.5 and 33 million barrels per day (mb/d). Although this is the first time since its last production cut in 2008 that OPEC has signalled its intention to take such action, it is too early to see this as a definite change in policy, let alone a done deal. Because this statement of intent comes with many risks and uncertainties. Nevertheless, this at least appears to be an initial signal that Iran and Saudi Arabia are edging closer to a joint stance. The market responded positively. Speculative short positions on further price declines were closed, pushing Brent oil well above USD 50/barrel in line with our forecast for Q3.
Many ifs and buts
But, as noted, there are quite a few traps and pitfalls ahead of the meeting on 30 November. First of all, OPEC has previously hinted several times at the possibility of lowering its production ceiling or freezing production growth. Until now, however, these noises never got beyond the stage of ‘verbal intervention’, possibly because the market reaction based on these announcements was sufficient to refrain from concrete action. This has made the market suspicious and raises justifiable doubts as to why OPEC, unlike before, would now be able to reach a consensus agreement and take concrete action. Adding to these doubts is the realisation that certain OPEC countries are demanding to be treated as exceptions. This may lead to extra uncertainties and compel other members to make greater sacrifices.
Oil production in both Libya and Nigeria is plagued by sabotage and unrest. So both these countries have upward production potential and could ramp up output as soon as their problems are solved. Whether and, if so, when and how much, extra oil can come onto the market remains very uncertain, however, and is almost impossible to estimate. The aforementioned statement of intent implies that any additional production in Libya and/or Nigeria would impose extra output constraints on the other OPEC countries to achieve the promised production ceiling. Whether the other members are prepared to make this financial sacrifice is highly debatable.
More or less the same applies to Iran, only in this case the extra production allowance results from the lifting of international sanctions. Iran has already significantly raised production in the past months but still has scope for more growth. The question is to what extent Saudi Arabia can allow Iran to continue stepping up its production, without losing market share.
But a genuine deal is also in Saudi Arabia’s best interests. Over the past two years, Saudi Arabia has relinquished the role of wing producer in order to focus exclusively on winning back market share. But the arrival of the new oil minister Khalid al-Falih has brought a wind of change. He is eager to put his stamp on the new OPEC policy. In addition, after being largely responsible for the failure of the discussions in Doha (Qatar) earlier this year, Saudi Arabia will want to demonstrate that it is still in control of the efforts to steer, or rather, stabilise the oil market. A second large disappointment in a row would be absolutely undesirable.
In its statement of last September, OPEC mentioned a maximum production ceiling of between 32.5 and 33 mb/d. Whilst the market responded positively to this news, it effectively entails a formalisation of the oil production growth achieved in the first half of 2016. Although lower than the production level in August (~33.5 mb/d) and September (~33.6 mb/d), this can hardly be termed a serious production cut, the reasons being that the previous official ceiling – effective until November 2015 – was only 31.5 mb/d.
What are non-OPEC countries such as the US and Russia doing?
How other countries will react is the next big question. Developments in Russia and the United States are being watched with particular interest. Russia has indicated that, if OPEC manages to work out a unanimous agreement to cut production, it will follow suit. Iran has also invited non-OPEC members to take part in this deal. But their participation is highly uncertain, as is Russia’s ability and willingness to lower its output if the oil price already starts rising as a result of OPEC’s interventions. After all, Russia’s economy is in a precarious state, so the country has a clear interest in maximising its oil production.
Even more interesting, perhaps, is the development in the US oil production sector. Now that the oil price is around USD 50/barrel, the number of drilling rigs is once again growing in the US. At these prices, it is evidently sufficiently attractive – and economically viable – to step up shale oil production again. Nevertheless, the market seems to be too optimistic in assuming that shale oil production will start growing again as soon as prices rise. After the heavy losses sustained over the past two years, investors may have less of an appetite for pumping more money into this high-risk sector. The industry will therefore take longer to revive than many currently expect. In addition, stocks of oil and oil-related products are very high, which will further dampen demand for extra oil. On the other hand, there are large capital surpluses in the market that are relentlessly chasing returns, even at the expense of some extra risk. Taking all this into consideration, we consider it unlikely that oil production in the US will rebound at the same pace as in the 2011-2014 period as soon as the oil price rises in the direction of a structural level of USD 60/barrel or higher.
The definite deal is to be hammered out at the next official OPEC meeting on 30 November. That is also the date when the market will hear to what extent OPEC is genuinely going to cut production or freeze production growth. Although a disappointment cannot be ruled out, there are also sufficient signals to suggest that this ‘oil price support action’ may actually succeed. There are two possible scenarios: an oil market with an OPEC deal, and a market without.
In the scenario where OPEC fails to strike a deal, the market could still move towards a supply-and-demand equilibrium. But that balance will take longer to materialise than in the scenario where a deal is secured to reduce output and/or freeze production growth. Besides a deceleration in production growth within the OPEC, the latter scenario will bring global output under further sustained pressure due to a lack of investments in the sector. In addition, we see that demand for oil at global level – and certainly from emerging countries in Asia – may be lower than the average of the past years. Nevertheless, the demand for oil is growing steadily, which will help to restore equilibrium in the market. In the event of a sudden OPEC-engineered oil production decline, a balance in supply and demand could be achieved faster with a possible overshoot towards shortages. When speculative investors start positioning for such a movement, the oil price can expect an extra injection of support.
That is why we believe that – whichever scenario prevails – the market will return to equilibrium in 2017. Our projection for higher oil prices in Q4 and in 2017 is thus mainly based on stagnating growth in supply, sustained growth in the demand for oil and a stable US dollar.
Gas price set higher
The price of Henry Hub gas (VS) staged an unexpectedly rapid rise in the past months. A combination of extra additional demand and lower supply has driven the price up from its lowest point in early March (USD 1.16/mmBtu) to nearly USD 3.10/mmBtu at the end of September. That is an increase of over 92%. Although our projections already assumed a higher gas price, this increase was faster and stronger than expected. Demand for gas rose on the back of three factors: more consumption in gas-fired power stations, higher demand for electricity due to more extreme warm weather (mainly due to the use of air conditioners) and an increase in LNG gas exports. We see this trend of strong demand alongside supply pressures continuing for a while longer. A further increase in the gas price is therefore not unlikely in our opinion. With the winter season just around the corner, demand could receive a boost from weather-related seasonal effects (a cold period) or production disruptions (e.g. due to hurricanes). We have raised our price forecast for 2016 from USD 2.10/mmBtu to an average of USD 2.50/mmBtu. Our year-end forecast for 2016 has been increased to USD 2.80/mmBtu and we now also project slightly higher prices for 2017 and 2018.