The upcoming meeting of the Organization of the Petroleum Exporting Countries (OPEC) on June 22 promises to be the most interesting one since November 2016 when Russia and OPEC entered into an agreement to curtail production to stabilize prices. Why? After more than a year of production restraint, they have successfully orchestrated a worldwide inventory drawdown, setting oil prices on a higher trajectory. This meeting, however, is going to be a contentious one.
Analysts’ estimate of production increase coming out of this meeting is in the 300,000 to 1.5 million barrels per day (bpd) range, with the high end representing a complete reversal of the 2016 cut. Russia is said to be pushing for this but many believe that it is a negotiation tactic. Most lesser producers within OPEC are angling for a stay of the production cap through the end of 2018 as agreed upon in the original deal.
The World Has Changed Since 2016
To read the positions of various players, it is necessary to make an assessment of the new world in 2018. US shale producers are perfecting their methods but seem to have hit a plateau; America is exporting oil at record levels; the reckoning of peak oil demand has set in among major producers (read: Saudi’s economic/social reforms and plan for the world’s biggest solar farm); America is starting a new sanction against Iran; Saudis and Iranians are fighting a proxy war; renewed Russian influence in the region; worldwide trade tensions; so on and so forth.
With Brent oil currently in the $70-80 range, many OPEC producers are roughly breaking even in social costs (oil revenues run these countries). It is imperative for these producers to maintain prices at this level for the foreseeable future. So far Saudi Arabia and Iraq have made it clear that they want to keep them in this sweet spot. Russia is making all sorts of trade deals with the Saudis and forging a longer-term alliance to lock in prices for the long term. Of the major producers, Iran, Iraq, and Venezuela are calling for the maintenance of production cap due to their unique circumstances, but they all share the issue of lack of spare capacity. Iran is preparing for international sanctions and Venezuelan production is plunging due to sheer incompetence. Libya’s on-again-off-again production shutdown rendered it powerless. Saudi and Russia are about the only two influential producers in this alliance who are ready and willing to raise output easily. However, they are both very comfortable with current arrangements, so there is no incentive to rock the boat too much.
Bearing in mind that OPEC has never taken a course without consensus despite internal strife, recent elevated geopolitical tensions between Iran and Saudi are not high enough to the point of ruining organizational protocol. Saudis can conveniently justify raising some output (200-300 thousand bpd) and pin it on the coming sanctions by the US for Iranian shortfall while appeasing Trump in his call for controlling gasoline prices. The Saudi prince understands the strategic interest of staying on Trump’s good side.
What About American Shale?
Turning to America. Although shale producers broadly break even in the $40s, signs of a production plateau are emerging. Price differentials between Midland, Cushing, and Gulf Coast as well as Brent-WTI are steadily widening. These can be attributed to the maturing of rig productivity, infrastructure bottleneck, and decreasing productivity of new drills due to the cannibalization of existing wells. Near term, shale firms are going to have to catch their collective breath while waiting for stars to align again, which means an immediate production surge is highly unlikely. As a result, the Americans are not likely to be effective in checking prices in the near future. And that is going to cede some power back over to OPEC.
Who’s Calling OPEC Irrelevant?
Despite lots of proclamations of OPEC becoming irrelevant, the cartel in the past downturn has largely met the internal organizational challenges and external threat from surging shale production. It executed beautifully the coordination with Russia and maintained (even exceeded) production quotas to achieve global inventory balance amidst escalating geopolitical tension among members. This speaks volume to the strategic view, discipline, and seriousness of its current leadership. One should not expect any less going forward.
Demand is Boringly Good
Global demand projections have been steady for 2018 and 2019 at around 100 million bpd. No immediate effects are expected from the trade spats. Despite turmoil from some emerging economies, the overall global economy is chugging along and is remarkably stable, for now.
Noise or Signal?
Going into the OPEC meeting, traders have definitely factored in some loosening of production quotas, and the recent price correction is reflective of that. We expect the production boost to be modest, gradual and spread out over a period of time. Given that prices are in a multi-year uptrend a continuation of upward momentum is widely expected, though a correction to the trendline support around $60 is a distinct possibility due to recent risk sentiment and the available excess production capacity. For now, a rapid move in either direction is hard to imagine based on the lack of geopolitical shocks and the all-around satisfaction with the status quo. Any short-term reaction to the outcome of the OPEC meeting is likely to be more noise than signal. Longer term geopolitical developments such as the second order effect of the unwinding of Iranian nuclear deal would be far more consequential.
Jeff Lee
Kronos Management, LLC
June 19, 2018
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