Oil post OPEC Deal – real change or just a smoke screen

At the end of November 2016, contrary to a lot of expectations, OPEC announced that it would bring its collective output down to 32.5 million barrels. The group also got a commitment from non OPEC members to reduce production. OPEC nations currently produce a total of 33.7 million barrels of oil every day. Under the deal, they will bring it down to 32.5 million barrels per day, with Saudi Arabia, Iraq, UAE, and Kuwait making the biggest cuts. A number of non-OPEC producers have joined OPEC in these cuts. They have agreed to reduce production by about 560, 000 barrels per day. This was followed by another news over the weekend where Saudi Energy Minister Khalid Al-Falih said that they will “cut the production substantially to be below” the target agreed last month with members of OPEC. A combination of all these new items have pushed crude prices up by almost 20% in a span of about 12 days. As a result, the current prices are close to 1.5 years high.

The question that the oil market is grappling with is – will this balance the market, how much will the prices increase or is this just a smoke screen and prices will fall back again?

Let’s first understand the deal - Saudi Arabia will cut about 500,000 barrels per day by reducing output to 10.06 million bpd. It may be ready to go a step further and reduce production below 10 million bpd. Iran plans to freeze output at close to current levels of about 3.8 million barrels per day. Kuwait, UAE, Iraq and Venezuela will also cut production. Libya and Nigeria will be exempted, as their output has been hurt by unrest and violence. Amongst non OPEC countries, Russia has pledged to reduce production by 300,000 barrels. Countries like Mexico and Kazakhstan have also committed to reductions. Although these may happen through natural field declines than active cuts. This probably covers 60% of the world’s oil producers and leaves out countries like USA, Canada, Brazil, Norway etc.

This was a huge negotiation within and outside OPEC to balance the needs and demands of all the nations while identifying cuts that can stabilize the prices. This is a clear turn from the market share strategy of Saudi Arabia, as all oil producing nations struggle through their budgets. Saudi Arabia has already burned more than $100 billion worth of reserves and has been forced to cut social services and government salaries to compensate for lower oil revenues, threatening stability in the kingdom.

This deal with big commitments across players has buoyed the market sentiment and some analysts are already predicting at $70+ oil by mid-2017.

Since Saudi Arabia had started the price war, the U.S. crude production has gone down by more than 1 million barrels, from 9.6 million barrels per day to 8.6 million barrels per day. Nearly $1 trillion in oil investment worldwide has dried up. However, the tussle between OPEC and shale producers is far from over. Huge trading activity happened on the back of this deal. Combined volumes of trading of Brent on ICE and WTI NYMEX surged past previous records. There is a lot of speculation that Shale producers are using this as an opportunity to hedge their future produce at these increased levels. As soon as prices started rising the rig count in US started increasing as well. It currently stands at the highest level for the year of 2016 in US. In the last month, U.S. crude production has gone up by about 200,000 barrels a day. This suggests that the upside on prices may be capped and will struggle to cross the $60 mark.

To say the least, there are a lot of skeptics of the deal given the history of OPEC and other countries.

For example, Russia has agreed to a cut by 300,000 barrels per day by January "if technically possible." It is a significant reduction, almost 25% of the overall OPEC cut. However, it comes on the back of significant increase in Russia’s output in the recent time. They have increased production by 520,000 barrels in the 2 months leading up to November, reaching a record level. So this reduction does not even get it back to the August levels. The history also suggests that Russia may not keep up its end of the bargain. In 2001 Russia had committed to cutting but they boosted production instead. Similarly even after the cuts Saudi’s will be above the levels they were at in 2015 before they started increasing production. So these cuts may be real, but they are based on a very high historic production level and may not help restore balance quickly. Also, in general OPEC countries are known to not meet their targets and produce more than that. Especially given its state Iraq seems most at risk of not meeting its quota commitments.

Even if all the cuts take place as planned, current inventory levels and shale production will create a ceiling on the prices. Inventory levels are 25% higher than historical averages. Also a lot of shale producers are said to have dug up wells and left it untapped ready to produce when the prices rise. So they could very easily surprise the market by increasing production quickly to take advantage of increased prices.

OPEC is trying to draw a delicate balance here. Reduce production enough to drain out inventories, restore balance and increase prices but not to increase prices enough to encourage shale production or encourage long term investment in production. In the short term China demand is going to be a big variable. China has been filling up its strategic and commercial inventory over last year and that demand should go away in 2017. Also the Chinese tea pot refineries may come under more scrutiny forcing some reduction in demand from them. On the other hand economic data from China is more encouraging boosting outlook of commodities. This will be a key in whether the reduction in supply and increase in demand can be balanced in early 2017 or later.

So, to figure out if it is a smoke screen or will it have a real impact analysts will be eagerly watching for compliance to cuts, China demand, shale production increases and inventory draw downs. This will create a lot of volatility in oil prices over next few months till the situation becomes clearer.

(This article is authored by Aditya Gandhi, Director- Technology, Sapient Global Markets)