OPEC’s rollover deliberations have become more complicated and perhaps more urgent after both market fundamentals and sentiment reversed last week. At the start of the week, industry optimism on the oil price outlook was upbeat, but within days, oil prices had fallen to the lowest levels in months. Here is our take on what happened.
Prior to OPEC’s November 30 meeting, we outlined the major challenges to achieving an agreement to reduce oil output and accelerate the rebalance of the global oil market. We called the challenge “daunting but doable” and largely anticipated both the form of the agreement and resulting bullish sentiment that followed. We also identified the considerable obstacles (i.e., the “daunting” part) that remained to be resolved or issues that could upset the agreement, and we credited OPEC’s skillful marketing of the agreement for reversing the then-prevailing bearish market sentiment. The promotional strategy, both internal and external, was a huge success and created positive momentum a full quarter before any cuts were set to be implemented.
On December 10, Part II of the OPEC strategy came into play when 11 non-OPEC producer nations agreed to contribute an additional 558 thousand barrels per day (mbd) to augment the OPEC cuts. The participating group included countries as diverse as Mexico, Azerbaijan, Oman, Equatorial Guinea, Kazakhstan, and Brunei to name a few. Russia had previously “committed” to contribute some 300 mbd of cuts to the total. And while issues of monitoring, compliance, internal allocation of cuts, natural declines vs. output restrictions, timing, and the like somewhat clouded the OPEC/non-OPEC output cut announcement, the net effect of the combined action pushed Brent prices above $55 a barrel, levels not seen since the summer of 2015! No small feat.
In our November commentary, we noted the quest for achieving a “Goldilocks” price equilibrium—one sufficient to bring in additional revenue to hard-pressed producers and begin to draw down the enormous surplus inventory (to accelerate the rebalance), while not significantly eroding consumer demand or incentivizing western producers to recreate the glut. And here’s where the math and fundamentals proved a bit more of a challenge.
Producers received a mixed and inconclusive set of market signals as the end of 2016 approached. The election of President Donald Trump was widely interpreted by U.S. producers to stimulate new domestic energy investments—both upstream and in delivery infrastructure. Congress’s adoption of a stop-gap funding bill included provisions for the sale of $375 million worth of crude (some 7 million barrels) from the nation’s strategic petroleum reserve. At the same time, revised estimates of China’s energy growth evidenced concerns of both economic slowdown and higher than previously assumed historical oil purchases directed to strategic stockpiling—making 2016 demand numbers look somewhat exaggerated while increasing the reductions expected for 2017.
As 2016 closed, company valuations were improving, hedges continued to increase, U.S. rig counts and production continued to rise, the forward curve began to flatten out, and speculative accounts raised their net long exposure in support of rising prices.
The alteration of the forward curve, coupled with higher prices and capital from hedged production (along with rising rigs counts and improved productivity), have led to additional supplies, both from inventory and new output. At the same time, winter demand (so far) has proved somewhat anemic, and refinery maintenance has contributed to lower crude demand. And while some OPEC producers, most notably Saudi Arabia, have met or exceeded their reduction commitments, compliance is spotty and collectively has not substantially removed enough of the inventory overhang to bring the market back in balance by the end of the second quarter (when the agreement is set to expire or possibly rollover). As a consequence, while investor sentiment was getting overheated in terms of optimism, last week’s events served as a wake-up call, shaking the market out of its complacency and forcing a sobering reconsideration of expectations and triggering a repositioning.
Ironically, as the industry gathered in Houston last week, the collective mood was far more upbeat than that exhibited in 2016. Early presentations emphasized the gains in rig counts, improved project economics, and rising well productivity, but then a reality gut check forced participants to examine an alternative future. Energy Minister Alexander Novak of Russia seemed to waffle on the timing and eventuality of fully implementing Russia’s reduction and did not commit to extending the current agreement beyond June. Energy Minister Khalid al-Falih of Saudi Arabia signaled that the Saudi cuts were evidence that the kingdom was indeed serious about moving the market back toward balance. He applauded OPEC’s collective action in that direction but also cautioned against “irrational exuberance” and warned that those taking painful cuts would not long abide free-riding competitors. On March 8, the U.S. Energy Information Administration (EIA) reported an 8-plus-million barrel increase in domestic crude stocks (the ninth consecutive weekly increase). And since only weeks before, money managers and hedge funds had increased their net long positions to record levels, the rapid bearish sentiment triggered a cascade of trader repositioning, causing oil prices to hit three-month lows well under $50 per barrel for West Texas Intermediate (WTI). OPEC’s own February production report (released earlier this week) did little to allay concerns, and IEA’s monthly figures now suggest a rebalancing later in the year.
In earlier comments we suggested that 2017 is likely to play out in one of two scenarios, where either prices fluctuate in wave-like fashion, reflecting the timing and pace of new, quick-cycle supplies relative to demand, or a world besieged by disruptive events (sanctions, trade wars, geopolitical events, failed states, etc.). Either way, the likelihood of an orchestrated smooth, gradual, and sustained price rise is unlikely to be in the offing, making OPEC and global producers’ individual and collective decisions in the coming weeks and months even more challenging.
Frank Verrastro is a senior vice president and trustee fellow at the Center for Strategic and International Studies (CSIS) in Washington, D.C.
Adam Sieminski holds the James R. Schlesinger Chair for Energy and Geopolitics at CSIS.
Guy Caruso is a senior adviser with the CSIS Energy and National Security Program.
Sarah Ladislaw, Kevin Book, and Larry Goldstein of the CSIS Energy and National Security Program contributed to this Commentary.
This article was originally published by the Center for Strategic and International Studies on 15 March 2017. It is republished with permission.