The last time OPEC (and Non-OPEC) member nations sat down to attempt a coordinated increase in oil prices by cutting production they succeeded… for about three months. Every since then, oil has been on a gradual declining path, boosted by a surge in US shale output and declining global demand, with WTI recently even sliding sliding below OPEC’s implicit price floor of $50/barrel. Which is why on May 25, after the failure of the first 6 month production cut, the same nations will try the same exercise, this time looking to cut output for 9 months, and hoping for a different outcome.
At least that is the general expectation. Overnight, BofA’s Francisco Blanch has released a note previewing next week’s OPEC meeting titled “OPEC: extend and pretend“, and which boils down to the 3 choices faced by OPEC: maintain, curb, or hike output. For its part, BofA believes that OPEC will extend cuts and hope demand recovers. Additionally, Blanch also states that oOPEC’s goal for the oil market is to reach backwardation, not a specific price level and does not believe that OPEC will proceed with deeper cuts as this would likely mean ceding more market share to U.S. shale production.
As Blanch explains in the summary, the global oil market deficit is smaller than the bank thought (see the dramatic, 500kb/d downward revision to global demand growth in chart 2 below) and as a result the cartel is struggling to bring down global stocks. This situation presents a major challenge for the cartel, as OPEC is targeting a shift in the term structure of global crude markets and not a specific oil price band according to Blanch: the idea is to penalize forward sellers and squeeze refiners. But soft demand in India and Mexico, a warm US winter, and an OPEC crude oil production overhang from 4Q16 have gotten in the way of a good plan.
Which brings up a question that has been floated by some (including this site) in recent days: “Why not cut further?”
Well, according to BofA, if OPEC cuts production even more, it will likely lose additional market share to US shale and prices may not move up much more. Conversely, if OPEC hikes output, oil prices could collapse to $35/bbl, setting the cartel on an even more difficult fiscal path. In our view, most OPEC members can not afford either scenario at this point. With many member countries already experiencing large government and current account deficits at current oil prices, neither lower prices nor a permanent loss in output are appealing options.
As a result, BofA is confident OPEC will stay the course, keeping production on hold over 6 to 9 months and hoping that demand improves.
Below are some some select excerpts fromthe BofA note:
The global oil market deficit is smaller than we thought…
We updated our global oil balances last week, lowering our Brent and WTI crude oil prices for this year and next by $7 to $10/bbl on average (see The crude reality). While we still see a sizeable deficit in 2017 of 610 thousand b/d, we are now projecting a balanced global oil market in 2018 (Chart 1). The change in our projections is coming from weaker than expected demand (Chart 2) and a faster-than-expected surge in the US rig count. The joint OPEC and non-OPEC cuts agreed last December are certainly helping support oil prices this year, but US shale production is coming back too fast into 2018.
… and the cartel is struggling to bring down global stocks
Crucially, total OECD inventories are now declining from much higher levels, as stocks actually built from 2,985 million barrels at the end of last year to 3,025 million barrels at the end of March (Chart 3). Soft demand in India and Mexico, a warm winter, and an OPEC crude oil production overhang from 4Q16 have prevented a faster draw in inventories. This situation presents a major problem for the cartel, as it is now apparent that it will take longer to reach the 5-year average levels in OECD total oil inventory targeted by OPEC. In particular, onshore crude oil inventories remain very high in the US (Chart 4), as a tight WTI-Brent spread in 1Q17 prevented a boost in US crude exports and continued to attract barrels to US shores.
OPEC’s goal is backwardation, not a specific price level…
A key point to understand is that OPEC is targeting a shift in the term structure, not a specific oil price level. After all, the price level for oil will be set by the most expensive marginal barrel in the market, which is US shale for now. In fact, OPEC first set the cuts in motion to shift the term structure of the market away from contango, contributing to flatten the Brent crude oil curve at a $55-57/bbl level (Chart 5). As we previously highlighted (see The oil price war is over), Saudi revenues will likely be higher over the next 10 years if it avoids a market share war with shale and other cartel members (Chart 6).
…in order to penalize forward sellers, squeeze refiners
Yet the market has realized in recent weeks that forward oil prices in the $55 to $57/bbl range are too attractive for shale producers. And as the US rig count continued to surge, inventors gave up on their long positions, helping oil prices drop across the term structure in the past month. With drilling activity and productivity gains continuing to improve, there is just too much shale in the pipeline. Yet North American producers are still under-hedged (Chart 7), suggesting that the next move up in crude oil prices as we approach peak seasonal demand is likely to center mostly on near-dated crude contracts (Chart 8) and not in 2018 calendar prices.
Putting it all together, BofA says that heading into the May 25 meeting, the cartel basically faces three choices.
- First, OPEC could cut production beyond the 1.2mn b/d agreed in December and encourage non-OPEC members to deepen the cuts.
- Second, OPEC could increase output aggressively and restart the oil price war.
- And third, OPEC could keep the cuts at the current levels for the next 6 to 9 months and hope for oil market demand conditions to improve.
What will OPEC do? According to BofA, “the cartel will extend the cuts and pretend everything is fine.” Which likely means that as oil prices fail to rebound, next March it will be same time, same place for OPEC which will again be scrambling to find some solution to a world in which it is no longer the marginal price setter.