Comments About OPEC and Oil Prices to AzerNews

Below you may read my comments about OPEC and oil prices, which I emailed to Ms. Sara Israfilbayova, a business journalist with Azernews, an English-language Azerbaijani newspaper. Ms. Israfilbayova had asked me some interesting questions about the present state of the oil markets. After my reply, Ms. Israfilbayova introduced my comments into her article “Expert: OPEC’s Success Depends On What Happens in U.S. (INTERVIEW),” which was published by AzerNews, first, on January 15, on its online edition, and then, on January 17-18, in its paper edition.   

     

January 15, 2018

LONDON

Q1. The OPEC+ decided to extend its production cuts till the end of 2018. Do you think it will be effective or not? Is there any chance of new countries joining the agreement?

It’s difficult to know whether the decision of prolonging by nine months the production cuts (in total 1.8 million barrels per day out of the market) until the end of 2018, taken by the Organization of Petroleum Exporting Countries (OPEC) and some non-OPEC producers including Russia at the end of November 2017, will be effective until December 2018. However, what is sure is that when the decision was taken, the production cuts were conceived as a component that might help to at least partially stabilize the oil prices—OPEC countries and the non-OPEC countries included in the agreement represent almost 60 percent of global oil production.

Extending the cuts, OPEC and some non-OPEC oil-producing countries, the latter led by Russia, did probably the right move in their quest to fight the global supply glut and to keep oil prices at about $60 per barrel. In addition, it was a good result the inclusion of Nigeria and Libya, two OPEC members that because of internal problems (attacks on oil facilities in Nigeria and an ongoing civil war in Libya) had previously been exempted from the initial cuts. If the deal goes through the whole 2018, the 24 countries that are now party to the agreement must stuck to their commitments. In December 2017, the OPEC members implemented 121 percent of the pledged cuts showing an optimal adherence to the deal—in total OPEC pumped about 32.47 million barrels of oil in December.

The extension deal will be reassessed in June 2018 at OPEC’s next scheduled meeting. In specific, this point is quite important to Russian oil companies, which wanted only a six-month extension and not a nine-month extension. In fact, Russian companies consistently fear that the already higher oil prices might permit the U.S. shale industry to gain market share at their expense.       

Q2. What are your predictions for the oil prices after the deal prolongation in 2018?

In these initial days of 2018, Brent prices are close to $70 per barrel, the highest value since 2014. However, there are several signs that market might be overheating. In practice, we have probably arrived at these prices too prematurely. Prices are currently high because of several factors. Among the most relevant, it’s worth mentioning: the extension cuts, declining inventories in the U.S. (partially linked to cold weather conditions as well), unrest in Iran and other areas, strong global economic growth, and oil future purchases by hedge funds and financial institutions (long positions). In specific, with reference to economic growth, recently the U.S. Energy Information Administration (E.I.A.) raised its 2018 world oil demand growth by 100,000 bbl/d from its previous estimate. If oil prices continue to be about $60 to $65 a barrel, it’s more than probable that U.S. oil production might well be on the rise again.

Over the course of the past months, Saudi Arabia and Russia have discussed consistently about a target price floor that could permit them to support oil prices, reduce the oil glut, and avoid losing market share to the benefit of the U.S. shale oil producers. The idea was that the best floor price was about $60 per Brent barrel. In addition, in the United States, 2017 was the year of an important mindset change across shale oil producers. In practice, from a growth-at-any-cost approach, shale oil producers realigned themselves with the basic concepts of return on capital and cash flow generation. However, if West Texas Intermediate (W.T.I.) rises and stays above $60, it will be quite difficult not to experience an increase in the U.S. shale oil production because, at that value, companies could consistently expand their profitability margins.

In practice, according to Barclays, at $60 a barrel, in 2018 U.S. shale production could increase by 1.4 million barrels per day (versus 1 million barrels at $50 to $55 a barrel), which would be equivalent to neutralizing almost one quarter of the OPEC/non-OPEC implemented cuts. In sum, this would mean lower oil prices. Of course, if a major geopolitical event occurs—for instance, an intensification of the proxy wars between Saudi Arabia and Iran or additional turmoil in Venezuela—this might always produce undersupplied markets, i.e., higher oil prices.

Q3. The success of OPEC largely dependents on the U.S. Thus, the OPEC countries face a dilemma. On the one hand, they need high prices, and on the other, prices should not reach such a high level, because in this case it will push the U.S. to increase production of shale oil. In your opinion, what should be done in this case?

Definitely, OPEC’s success is dependent on what happens in the United States, i.e., whether U.S. shale oil producers are able to increase production nullifying OPEC’s efforts at curbing production in order to support prices and reduce inventories. Indeed, OPEC’s game is absolutely not an easy game, because Saudi Arabia and the other oil-producing countries need first to find and then to maintain an oil price that satisfies, at least partially, their budget requirements, that cuts commercial oil inventories down to the five-year average to rebalance the oil market, and that does not guarantee excessive profitability to the U.S. shale oil producers. Of course, such an equilibrium is not easy to achieve and to maintain.

The next six months will tell us a lot more about how the U.S. shale oil industry will respond to these new higher prices. It’s evident that if shale oil output begins to increase faster than it was expected, OPEC and non-OPEC oil producing countries will be forced to halt production cuts earlier than they have thought. For the time being, according to Saudi Arabia, in December 2017, O.E.C.D. inventory stocks were still 150 million barrels too high. In addition, calendar spreads for 2018 have tightened significantly over the last six months hinting at a sustained period of oil undersupply. In general, drilling rates, i.e., an increase in production, follow the changes in the future markets with a gap of 4 to 5 months.

Q4. What other method can be offered to balance the oil market?

No, too much is currently at stake in order to think of other reliable and implementable strategies to balance the oil markets. In specific, the emergence and the real impact of the U.S. shale oil industry must still be fully understood. As mentioned above, only in the past year has the U.S. shale oil industry succeeded in implementing a more financially sound behavior. On top of this, if on the one hand, the 24 countries that are now party to the agreement concerning the production cuts have been able to extend the cuts, on the other hand, they have already shown significant differences concerning the strategy for managing oil prices.