“The risk seems to be the greatest on the downside again” and speculation of OPEC production cuts has “faded fast,” says Saxo Bank head of commodity strategy Ole Hansen. “China and South Korea are both helping the market return to fundamental focus where it is worried about demand.”
But the biggest downward catalyst overnight as noted previously, was not demand concerns but a return of oversupply fears following a note by Goldman’s Damien Courvalin who warned quite explicitly that “cuts are unlikely” in what Goldman dubs the New Oil Order, and that in the current rebalancing phase, oil prices will “remain between $40/bbl (financial stress) and $20/bbl (operational stress) until 2H16. This phase will be characterized by a highly volatile and trend-less market with the price lows likely still to be set.” But most importantly Goldman writes that “given the likely time necessary to enact such cuts, the continued large builds in US and global inventories and the fast pace at which US Gulf Coast spare storage capacity is filling, it may already be too late for OPEC producers to be able to prevent another large decline in prices.” Here’s why:
The past week featured headlines suggesting that OPEC producers and Russia would meet in February to discuss a potential coordinated cut in production. Despite the sharp bounce in oil prices that these headlines generated, we do not expect such a cut will occur unless global growth weakens sharply from current levels, which is not our economists’ forecast. This view is anchored by our belief that such a cut would be self-defeating given the short-cycle of shale production and the only nascent non-OPEC supply response to OPEC’s November 2014 decision to maximize long-term revenues. As a result, we reiterate our view that prices need to remain low enough to force fundamentals to create the adjustment back towards a new equilibrium. We believe this inflection phase requires oil prices to remain between $40/bbl (financial stress) and $20/bbl (operational stress) until 2H16. This phase will be characterized by a highly volatile and trend-less market with the price lows likely still to be set.
The full list of Goldman points listed below, which incidentally are quite accurate, is a useful primer for any oil bull who hopes that a prompt supply cut is in the cards:
- The potential for production cuts became once again a key driver to oil prices following headlines last Wednesday (January 27) that Russian officials had decided to talk to Saudi Arabia and other OPEC members about output cuts of 5% although no discussions are scheduled at this time and other headlines suggested the move was instead initiated by Saudi Arabia or Venezuela. On Thursday, ministers from Saudi Arabia and the UAE were instead commenting on their continued oil field investments to sustain production. Despite this lack of clarity, oil prices rallied 7% last week, taking 1-month oil price volatility to 70%, its highest level since April 2009.
- We continue to view a coordinated production cut as highly unlikely and ultimately self-defeating. The decision made by OPEC in November 2014 and again in December 2015 to sustain production is the one that maximizes their revenues medium term. While fiscally difficult in the short term, it was nonetheless necessary in the face of strongly growing higher-cost non-OPEC production (see The New Oil Order, October 2014). And after a 14-month wait, the strategy is finally bearing fruit, with non-OPEC producer guidance pointing to production declines since oil prices fell below $40/bbl a few weeks ago. We had identified this as the required pain threshold to see sufficient financial stress and shut funding markets to finally impact forward production (see Lower for even longer, September 2015). As such, a cut that would bring prices above $40/bbl now would undermine this only nascent adjustment. Exacerbating the difficulty of enacting a correctly sized cut in our view are (1) the current high price volatility, (2) the remaining uncertainty on the size of the oil oversupply, (3) the continued rapid fill of remaining storage capacity, and (4) the potential for US production to quickly respond.
- We believe that the spring 2015 rally in oil prices has increased the resolve of core OPEC producers to stick to their policy of sustaining production and let oil prices rebalance this market (as they have repeatedly commented in recent months). Specifically, last year’s price rally was quickly followed by an increase in the US oil rig count and we would expect such a response once again should prices rally near $60/bbl. In fact, recent E&P cost and efficiency guidance and producer comments at our equity analysts’ Energy Conference in January suggest that this threshold is now likely even lower. Further, the velocity of such a response will be much greater this time as the average number of days from beginning of drilling to production collapsed by 40% from 1Q to 3Q15 to reach 80 days in the Permian. The magnitude of such a response will also be supported by the acreage highgrading that occurred last year, lower legacy decline rates and average first 3 months’ production for new wells up by 25% over that period.
- Such a production cut would further require cooperation between OPEC members. And while Venezuela, Algeria and Iraq – which for the first time last week hinted at welcoming cuts – would agree to such a decision, Iran’s production ramp up would likely be a significant hurdle to any OPEC action. While Iranian officials have commented on their desire to not flood the market, their production recovery target remains aggressive and their desire to regain market share steadfast. Iranian observed exports have already picked up in January to their highest level since April 2014 despite these remaining to destinations permitted under sanctions given reported caution in granting ship insurance to vessels carrying Iranian crude to new customers. As a result, a production cut would likely need to accommodate continued growth in Iranian production, an agreement which seems unlikely given recent tensions with Saudi Arabia.
- For Russia, the desire to join a coordinated production cut would need to come from the government as our Russian energy analyst, Geydar Mamedov, estimates that Russian oil producers remain free cash flow positive even at $30/bbl given the concurrent Ruble depreciation (we continue to expect steady production growth in 2016 and 2017). The strain of low oil prices are visible at the government level however as $30/bbl oil prices would leave the 2016 federal budget deficit reaching 5% of GDP vs. the government’s/President Putin’s 3% target according to our Russian economist Clemens Graffe. Since oil taxation is progressive and causes the deficit to widen faster as oil prices decline, current prices raise the risk of a potential increase in oil taxation and in turn lower production, which should it occur, would be an incentive to have other countries cut output at the same time. While a risk, our Russian economist estimates that given the need for legislative changes in order to institute tax changes and consensus expectations for prices to recover from current levels in 2H16, the pressure would likely be instead on better collection rates and an increased allocation of spending into regional budgets or off-budget to meet the 3% deficit threshold (see Russian budget pressures shifting from discretionary to structural, December 2015).
- Despite our belief that no cut will occur, we nonetheless reviewed the recent history of production cuts as well as their price impacts. First and foremost, OPEC and non-OPEC (mainly Russia, Norway, Mexico and Oman) coordinated production cuts occurred in periods of weak economic and oil demand growth, which despite current concerns are not our economists’ forecasts. That was the case in 2009 (Financial Crisis), 2001 (September 11 attacks) and 1998-1999 (Asian Crisis). As we have argued before, we believe that weak global growth also remains a required condition for OPEC production cuts this time around. Second, while the headline cuts were large and did help support prices upon announcement, compliance was weak initially with production cuts delayed (by a year in 1998-1999). Consequently, prices only sustainably recovered once inventories started to draw which coincided with the lagged cuts in production.
- As a result, should a cut occur, its impact on inventories would matter most, just as the current non-OPEC guidance cuts will only support prices once inventories stop to build. While prices may rally initially upon announcement, we would expect this move to fade and the oil forward curve to remain in contango until inventories decline, just as was the case in 1998-1999. Consistent with our current forecasts, the rise in long-dated prices would only occur once the inventory normalization is well under way as only then will new production need to be incentivized.
- Most importantly, given the likely time necessary to enact such cuts, the continued large builds in US and global inventories and the fast pace at which US Gulf Coast spare storage capacity is filling, it may already be too late for OPEC producers to be able to prevent another large decline in prices. As a result, we reiterate our view that prices need to remain low enough to force fundamentals to create the adjustment back towards a new equilibrium with this inflection phase requiring oil prices to remain between $40/bbl (financial stress) and operational stress at $20/bbl (well-head cash costs) until 2H16 with the price lows of this phase likely still to be set.
And the charts:
Exhibit 1: The US shale production response to higher prices will be rapid
Days to production – quarterly mean of Permian wells
Exhibit 2: OPEC production cuts in 1998 occurred because of weak demand and did not generate sustained rallies…
WTI oil prices and forward curves ($/bbl)
Exhibit 3: … as OPEC production cuts were well shy of agreed targets
WTI oil prices (lhs, $/bbl); OPEC crude oil production (thousand barrels per day, rhs)
Exhibit 4: Oil prices troughed only once inventories started to draw
WTI price ($/bbl, lhs); OECD commercial stocks (crude and products, million barrels, rhs)