Energy Monitor – The balancing act of OPEC

by: Hans van Cleef

  • IEA data shows that the oil market reached a balance between supply and demand…
  • …but every sign of doubt trigger new price swings
  • There is an upward potential for oil prices, but there is also room for temporary price weakness
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Balance has been found, now what?

The latest International Energy Agency (IEA) Oil Market Report shows that there is a balance between global supply and demand. So the production cut agreement by several oil producing countries (both from OPEC and non-OPEC) actually is working. Market expectations are high that this agreement will be extended for another nine months after it expires at the end of March 2018. The IEA Report also shows that supply and demand will probably remain in balance in 2018. Therefore, it is unlikely that  the excessive global crude inventories will decline.

A balanced market means the equilibrium is fragile. The equilibrium could easily be disturbed and this will directly impact oil prices. In short, oil prices will probably be more volatile. In the coming weeks, investors will search for possible developments that could upset this equilibrium. For example a rise in oil prices could trigger expectations that US (shale-) production may increase, resulting in higher crude inventories. On the other hand, lower oil prices could lead to higher consumption and, even more importantly, increased pressure on future investments by International Oil Companies.

Expectations about US production growth overrated?

Expectations about higher US crude oil production may be overrated. In recent months  oil prices have increased, while the growth of US drilling rigs came to a halt and even declined somewhat. There has been a rise in US production though, because of a rise in efficiency and the activation of some of the ‘drilled but uncompleted wells’ (the DUCs).

Oil  production at several oil fields in the US has declined already. This is because the easy accessible crude oil is already in production and new oil is much harder to find. To keep US production at current levels, and to meet investor expectations about the future rise in production, there will still be a large need for further investments in the sector. If US treasury yields continue to rise (we expect 10y Treasury yield to increase to 2.5% by the end of 2018) – the financing of these investments will become more difficult. Therefore, it will be uncertain whether the US oil production will grow as fast as financial markets currently anticipate.

OPEC restarted its verbal intervention strategy

On 30 November, OPEC will meet for its regular meeting in Vienna. Market expectations suggest that OPEC could give  more details about if it will or will not extend its production cut agreement together with Russia and non-OPEC members. Early October, the leaders of Saudi Arabia and Russia already met. They indicated their willingness to possibly extend the agreement in order to stabilise the market. Nevertheless, that does not mean that the decision has already been taken. This verbal intervention followed increased pressure on the oil prices and is a way to calm markets as it has been used in the past. Often comparable words have proved to be enough to prevent a further decline in oil prices. These words often trigger a modest recovery. Words can have a desirable effect but at some time action is expected.

The question  is if a new production cut agreement is really necessary. According to the IEA Report, the supply and demand will be in balance in 2018 only if the production cut agreement of -1.8 million barrels per day is extended. However, this may not be necessary if global demand growth remains strong (in line with OPEC expectations). If global oil demand is stronger than forecasted, there is more room for oil production growth. Furthermore, these IEA expectations do not take into account the risk of renewed geopolitical tensions affecting production. Moreover, the IEA report does not factor in  production disruptions due to weather related issues. We can imagine that OPEC may want to wait longer (until there is more clarity about the situation in Q1 2018) before deciding on whether to extend the production cut or not.

A moderate oil price appreciation, with room for temporary oil price weakness

We keep our oil price forecasts unchanged. We expect that oil prices will probably trade sideways within a relatively small trading range during the coming weeks. Market expectations about changes in global production will continue to trigger oil price movements. Still, these will be most likely be modest and temporary. Signals from OPEC could stabilise oil markets if prices weaken to much, while lower US crude oil investors could result is higher oil prices. The release of the OPEC and IEA World Energy Outlook Reports during the first half of November and the OPEC meeting on 30 November will probably give oil prices more direction.

Our 2018 price outlook indicates the possibility price volatility. As soon as Brent oil surpasses the USD 60/bbl mark, prices will likely hit a ceiling as speculation for more US crude production will gain attention again. That is why we expect oil prices to ease afterwards (our Q2 forecast is lower than Q1). We expect oil prices to strength again in the second half of 2018. Oil prices could rise above USD 70/bbl in the course of 2019.

Oil producers may only need oil prices of USD 60-65/bbl to produce at or above break-even levels to meet global demand. However, as soon as market investors start to anticipate a oil shortage, oil prices  will probably rally further. This is possible as long as international Oil Companies do not increase their investments, the global demand growth for oil remains solid and crude inventories continue to normalise.