By Sohbet Karbuz, for Trend:
On November 30, OPEC decided its first output cut since 2008. In the two days following the announcement of the cut, Brent crude oil price registered more than 16 percent increase. Because of this, we have seen many people arguing that OPEC is not dead yet, “OPEC empire” strikes back, OPEC is still relevant, etc.
In my opinion this time the so-called "deal" was a certification that OPEC has a big mouth but no teeth, low prices are hitting the economies of its members and they cannot do much about it.
Remember, just two years ago, OPEC decided not to cut output. At that time Ali Al-Naimi, predecessor of Saudi Energy Minister Khalid Al-Falih, proclaimed it was not "in the interest of OPEC producers to cut their production, whatever the price is" and that it didn't matter whether oil prices went "down to $20, $40, $50, $60 a barrel -- it is irrelevant." We all know what happened to the economies of OPEC members in the past two years. OPEC press release for instance says that current market condition "threatens the economies of producing countries.” So, they had no option but cut production to help push the prices upwards. In May 2016, al-Naimi was replaced by Khalid Al-Falih.
The current OPEC agreement shows that Saudi Arabia is not anymore a swing producer, and that OPEC does not anymore have power, or at best struggles to balance world oil supply and demand.
In Algiers meeting three months ago, OPEC ministers announced that they need to freeze daily output between 32.5 and 33 million barrels. Since then they have been working on the formulation of such a freeze and possibly a cut. It took a while because the intention was not to upset anyone.
At the November 30 meeting, the OPEC announced that they agreed to cut daily production level from 33.7 to 32.5 million barrels per day, between January and June 2017.
The best way for not to upset anyone and hence come up with a reasonable agreement or a face-saving deal was to have proportionate cuts of 4.5 percent in members’ output.
Libya and Nigeria are exempt from the deal because they are still trying to recover from previous outages. Angola’s reference level was backdated to September 2016 in order to take account of scheduled maintenance which lowered output in October. Iran's reference level was backdated to pre-sanctions period so that the country is in fact allowed to increase its output by 90 kb/d. Indonesia, currently a net oil importer, decided to suspend its OPEC membership. At the end, only a few countries have pledged to cut output.
At the end of the day, the deal is indeed a production freeze for some members, a cut for some others, and an increase for a few.
The “deal” is in fact nothing more than a face-saving initiative, because otherwise the production cuts, to take effect from January, are largely based on what the OPEC members were producing in October 2016, reference base to crude oil production adjustments.
What is the point of selecting a reference month when OPEC output was at a record high? Some key non-OPEC countries are expected to the cut their production by 600 kb/d. Half of this amount is expected to come from Russia. Russia's oil production was also at the highest in October 2016 (since the Soviet-era peak). So, the possible Russian contribution to the OPEC deal is also not a real production cut. In fact we are likely to have production freezes, not real cuts.
On November 30, the day when the OPEC meeting was held, the oil market was very volatile. Combined volumes in the ICE and CME crude oil contracts on that day hit all-time high. The total amount of crude traded on both exchanges (futures+options) was around 5.3 million contracts, equivalent to 54 times the daily world oil supply.
Market fundamentals and expectations of traders about the future are reflected in the prices in the paper barrel market, where many other factors also come into play. Seen from this perspective, the recent erratic oil price dynamics are indeed due to the weighted combination of expected market fundamentals and speculation, which, again, are affected by many factors.
The main driver of market sentiment should be the facts, and not fears, concerns and worries of traders against perceived risks. But since the oil market is not transparent, free and efficient market, traders' expectations will continue to put additional pressure on prices.
Look at the pathetic oil market data, especially monthly data; you will understand what I mean. World oil statistics are very far from perfect. Data on spare capacity, production, consumption and inventories are mostly estimates or best guesses, particularly for most of the non-OECD countries.
Even OPEC doesn't believe what its members report to the Secretariat, which is why OPEC uses data from secondary sources to monitor the market, including production in its member countries. But where do those secondary sources get the data from is a question nobody asks. What an irony! In an environment where nobody can verify and prove the real production, cheating will prevail. This means the implementation of the deal in terms of self-compliance and the commitment to reduce production is vital for the “deal” to be successful.
Production level is said to be monitored by a committee of representatives from Kuwait, Venezuela and Algeria, plus two non-OPEC participants. I really wonder how they will monitor it. Cheating has been a common feature of the OPEC production cut decisions in the past. I don’t see any reason why this tendency should change this time because of the concerns about losing or defending market shares of big producers particularly in Asia.
This brings us to another issue which is crucial for the oil market. The OPEC "deal" is supposed to remove 1.8 mb/d of oil from the market for 6 months - 1.2 mb/d from OPEC plus 0.6 mb/d from non-OPEC countries. In fact, the agreement, if succeeds, will remove that amount from the world oil production, not from the world oil trade. In other words, we should indeed be talking about the exports from the producer countries, rather than production. But it seems that nobody cares about that.
It is too early to forecasts how the OPEC deal will impact the global oil market. If this "deal" somehow achieves its intended aim it is highly likely that oil prices will rise, to $60 or above per barrel according to many observers. This could weaken demand growth in 2017, erasing the benefits of production cut. Moreover, price increase may accelerate the drawdown in stocks and tighten the supply/demand balance in the first half of 2017. The problem is that crude inventory levels are above historical averages. This is why the question whether the inventory overhang can be brought down to historical range, and if yes, when, still can not be answered.
Higher prices will bring along two more crucial issues: the reactions of the Trump administration coming to power in the US in January, and the US shale oil industry which might be a big beneficiary of the OPEC deal.
The US crude oil supply expectations for 2017 change quite fast in relation to the price of oil. Current expectation is about 6.5 mb/d throughout 2017. In addition, shale oil production in Permian has so far been very resilient. Breakeven price levels for majority of shale oil producers are estimated to range between $50 and $70 per barrel. This means that cutting OPEC production and an increase in oil prices may have a double effect to open the door for shale oil producers as well as other non-OPEC producers to ramp up their output at the expense of those OPEC members who promised to cut production.
The production cuts are planned to last for six months. Then what? After six months OPEC will assess the market and decide whether to extend its ill-fated policy. We can be sure that between December 10, when OPEC plans to hold a meeting with non-OPEC countries in Vienna, and OPEC's next ministerial meeting on May 25, there will be plenty of formal and informal meetings that will make oil prices a permanent item in global agenda in 2017. Whether the immediate upward push to oil prices following the OPEC meeting will be kept or lost is not easy to judge, but optimism created for prices to stay well above $50 in 2017 might fade away faster than thought. The current Brent forward price curves do not show a long-term impact of OPEC deal on the oil market.
Another aspect of the OPEC deal is its possible impact on natural gas markets, especially LNG. In 2016, around 80 percent of global LNG supply was priced on contracts linked to benchmark oil prices or prices of oil products. Besides, most LNG ships burns oil which means that increase in oil prices will have a direct impact on shipping costs. An increase in oil prices, hence would translate into higher LNG prices, albeit not proportionate, due to the oversupply in the LNG market.
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Sohbet Karbuz is director of Hydrocarbons at Mediterranean Energy Observatory (OME).
