November 30 will see the 171st Meeting of the Conference of the Organisation of the Petroleum Exporting Countries (OPEC) take place in Vienna. Pressure has been steadily building for OPEC to take concrete action to back up its September 28 decision in Algiers to target production for OPEC-14 between 32.5 and 33 mb/d, in order to “accelerate the ongoing drawdown of the current stock overhang and bring market rebalancing forward.”
While the Brent crude price has gyrated up and down since late September, it is important to note that nearby time spreads have continued to weaken from around $0.50/bbl to over $1/bbl in contango. This time spread is an indication of the cost to store the excess supply that is coming to market and indicates that not only does the market continue to be over supplied, but it is getting more expensive to store the excess barrels.
At these levels the market is pricing to store oil in ships, indicating that commercial availability of onshore storage is constrained. Storing oil in ships removes those ships from the market, leading to a subsequent increase in freight rates, which in turn makes floating storage more expensive, pressuring the market deeper into contango. Consistent with this perspective, VLCC rates have hit six month highs in the past few weeks.
This observed weakening of time spreads is aligned with the physical reality on the ground. Indications from all channels are that OPEC supply to market rose sharply in October. Petro-Logistics’ weekly OPEC Production Monitor shows supply exceeded 34 mb/d, up over 1 mb/d since June. November is on track to sustain OPEC supply around these levels and Russian supply has also been increasing, setting post-Soviet era records for production and more importantly exports of crude oil and refined products.
In the debate of whether OPEC will or will not cut, it is important to understand that it is not enough to simply cut supply to balance with demand, which itself would be an achievement. The excess inventory that has accumulated over the last two years still exists and it is very material, approaching one billion barrels by IEA calculations. And it’s still growing.
To truly address the imbalance between supply and demand, OPEC will need to cut and cut deeply to make a difference. OPEC faced a similar scale challenge in December 2008, with oil prices having fallen by almost $100/bbl since that summer. OPEC managed to find sufficient alignment to implement material cuts and support prices until oil demand recovered with the global economy. On that occasion, OPEC made a significant commitment to cut production by 4.2 mb/d. While not achieving this lofty goal, the results were impressive. By OPEC’s secondary sources reckoning, they cut by around 2.7 mb/d in the first half of 2009 compared to an agreed baseline of September 2008 production. This figure includes 250 kb/d of increased production from Iraq in the time period. (Iraq was exempt from quota as production was still recovering from the first and second gulf wars).
In this context it is worth considering the potential scenarios that may begin to emerge next week in Vienna:
- The member countries fail to reach agreement, separating in disarray as they did in April in Doha. This outcome would be likely to disappoint the market as well as continuing to add to the excess global inventory. Iran, Iraq, Saudi Arabia and Russia would continue to focus on expanding production, depressing prices and keeping them low through 2017. This dynamic increases the risk of political supply disruptions in several states, including Iraq, Venezuela, Libya and possibly Nigeria. A likely consequence of this scenario is that OPEC meets again early in the new year to again try to agree a meaningful cut.
- OPEC continues trialling the recent practice of using communicating as a tool to steer the market without the need for physical intervention. This strategy has been effective at times for Central Banks in Europe, Japan and the US, however it is less well suited to the oil market, which is grounded in the reality of dealing with excess oil supply. With around $1/bbl of contango in the front of the curve, the physical market for oil continues to indicate that tanks are pretty full. If the answer from Vienna turns out to be a hollow verbal agreement to curtail supply with limited hard action to back it up, more oil will come and continue to pressure the front of the curve, dragging down oil price until something gives to help rebalance the market. Under this scenario, oil prices are likely to initially recover on news of an agreement being reached, but within a few weeks the weight of continued surplus production will drag the market lower again with a high probability of prices falling through the $40/bbl mark before end of Q1 2017.
- OPEC achieves a strong consensus not just in the concept of a cut but also the reality of it with member countries collectively reducing production to between 32.5 and 33 mb/d, as indicated in Algiers. In this scenario Saudi will likely carry a higher proportion of the adjustment, however all or substantially all countries will be expected to contribute. In 2008/09 Saudi cut 15%, Kuwait and UAE 12 to 13%, Algeria, Libya and Nigeria 10% and the others between 2 and 5%., so it is possible. Working against this scenario are the twin concerns of increased supply from Russia and the US and the prisoners dilemma that highlights to each OPEC member that they are best off if everyone else complies and they cheat.
We believe the most likely scenario is #2 with much fanfare from OPEC about an agreement being reached in Vienna but most of the actual burden to cut is leveraged on Saudi with potential support from UAE and Kuwait while the others continue to produce at or near current levels, or higher. At first this outcome may look like scenario 3, making it important to really follow what happens next.
To identify which outcome is being implemented in reality it will be important to watch exports, such as through Petro-Logistics’ weekly OPEC Production Monitor, and to keep a keen eye on time spreads. If they strengthen, OPEC will be making a real difference, if they weaken further, the glut continues.