Since the Organization of the Petroleum Exporting Countries (OPEC)‘s “extraordinary meeting,” the big question now is will they or won’t they cut oil supply?
As a reminder, the initial proposal coming out of the late-September meeting called for a production range of 32.5-33.0 MMbbls/d, below the 33.7 mil bpd of observed supply in October. The prior OPEC agreement to cut in 2008-2009 coincided with a collapse in oil demand. This recent period of price weakness is a result of a surge in supply. To date, there are no signs of material deterioration in oil demand. So why the change of heart? Why the apparent desire to pull forward the pace of rebalancing instead of staying the course? Since news of the preliminary OPEC supply cut agreement surprised the market, there has been much speculation but little concrete terms of a deal.
Possible Reasons for OPEC’s Actions
Saudi Arabia Special Interest It is interesting to note that most public sources see Saudi Arabia as the protagonist behind this OPEC strategy shift from its prior, more aggressive maintain/grow market share stance. Behind closed doors, it’s anybody’s guess on the true intentions of this preliminary deal as talk alone has a tendency to shake out short crude positions across commodity books—OPEC knows this and has exploited it in the past. Nevertheless, the about-face from the largest producer within OPEC has the oil markets’ attention and should increase the probability of a deal actually coming to fruition. Compliance is another question altogether and the market will seemingly take any fixed supply targets with a grain of salt, but let’s think about the factors that have seemingly brought OPEC negotiations to this point.
Fiscal Break-Evens Matter Despite the fact that some of the biggest OPEC producers enjoy very low drilling costs, fiscal break-evens still matter and oil revenues are the key to balancing budgets across the Middle East. While almost all Middle East countries have performed budgetary cuts in recent years, the IMF projects that the oil price necessary to balance the budget for every single OPEC producer is above $50/bbl. On a production-weighted basis, the average fiscal break-even for Middle East OPEC members is closer to $65/bbl and many consultants believe this figure will only rise in the years ahead as many countries embark on large downstream capital programs to diversify away from oil. If the current oil futures strip never reaches $60/bbl, most OPEC members would experience deficit spending for the foreseeable future. So with a supply cut, could OPEC members simply be betting that higher oil prices offset the lower production, netting a higher absolute revenue figure for the country? Saudi officials should have this math in mind in drafting the documents ahead of the planned IPO of Aramco in 2018.
Fear of Oil Producers Reaching Their Limits There is also a debate amongst oil pundits as to whether a potential OPEC supply cut is in fact an indication that its largest member (Saudi Arabia) has maxed out its productive capacity. This same rationale is used in discussing Russia’s apparent willingness to join any OPEC agreement after its own production reached its post-Soviet highs. This plays into the idea that OPEC’s commentary on “medium-term risk to the oil market” represents a fear about the potential for a negative (and structural) impact to oil demand from an eventual spike in oil prices that is driven by a lack of medium-term supply.
Recall that the rapid oil price inflation of 2007 and 2008, when oil peaked near $140/bbl, hurt demand. If the market begins to assume that the two largest oil producers are nearing their respective productive capacity limits, crude inventory no longer represents an overhang but rather should be priced as a reserve against future shortfalls—which against the backdrop of consistent demand growth means $50-$60/bbl is too low.
To be clear, there is still no consensus amongst oil market observers on whether an OPEC deal will be struck heading into the late November meeting. The most widely cited deterrent to an agreement stems from the belief that there is a group of producers (namely, Iran and Iraq) that will not comply with a cut until they regain their respective market shares. Additionally, many believe that a higher price today would only open the door to new longer-cycle, non-OPEC projects, which is self-defeating to OPEC’s longer-term market share. With more questions and speculation than answers regarding OPEC policy, the reality is that a rebalanced oil market needs a price above $60/bbl over the next several years, and perhaps OPEC is simply sick of waiting.
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