You can't please 'em all ..... OPEC extends but the market is unimpressed

Friday 26th May 2017

You can't please 'em all ..... OPEC extends but the market is unimpressed

ref :- "OPEC Leaves Market Guessing on Exit Strategy After Oil Pact", Bloomberg Markets

Last night OPEC announced that along with its non-OPEC partners it will extend the 1.8m barrels per day production cuts instituted at the start of the year by a further nine months to end-March 2018. The reaction has been interesting on a number of levels. The price reaction was an object lesson in market dynamics, but beyond that the decision has raised more questions than it answered.

Immediately after the news broke, Brent Crude dropped 5% to $51.24.  Those new to the markets might wonder if that's an entirely logical response to the unveiling of a plan to extend production curbs for nine months, especially as it wasn't that long ago that producers opened discussions on prolonging the deal for a mere six months. The fact is though that oil prices had rallied more than 13% since the lows set in early May, and about 6% of that took place after the Saudis and Russia had called for the longer option. As other producers fell into line, and the big boys began to borrow ECB boss Mario Draghi 's phrase about doing "whatever it takes" to achieve their goals, it was becoming ever more likely that the market was fully positioned for a nine month deal, and was going to need something more in the way of deeper or longer cutbacks to maintain the momentum. Plainly, they didn't get it .....

Most of the speed and size of the fall can be ascribed to disappointed speculative longs getting out of their positions, rather than a suddenly bearish re-appraisal of the fundamentals (there's a small rally going on this morning as we write). Just as it had been before yesterday's decision, there's a debate going on about whether the extended cuts will be truly effective with well-respected oil gurus on either side of the argument. You could argue that OPEC has already been partially successful by dragging prices up from the calamitous (for producers) sub-$40 levels seen little more than a year ago. Perhaps.... but their stated aim is to re-balance supply and demand by engineering a fall in the glut of oil inventories, at record levels only recently, and thus secure a stable and more profitable price for their product.

Inventories actually rose in the first quarter of 2017, which seemed to suggest that the game-plan was not working. But the last weeks have seen some reduction in crude stocks that the bulls believe is an early sign of the policy taking effect. It might take longer than was originally intended, but probably by the end of this year and certainly by end-March 2018, they see the measures achieving the desired balance and a solid base for prices (say $60 ?).

Needless to say, others are not quite so sure. One should probably mention increased output from producers even within OPEC, such as Libya and Nigeria who were excused production curbs. But the main problem for the cartel and its allies in their attempts to draw down inventory and boost prices is the resilience, and the resurgence, of US shale drillers. These guys are not to be underestimated ..... though clearly that's what the Saudis and others have consistently done. Huge improvements in efficiency brought on by those very low price levels engineered by OPEC's free-for-all policy mean that some shale producers can now operate profitably with oil at $40. An awful lot more can do so at $50..... and assuming for a moment that the price does move higher, that will only bring more shale rigs into the game. The argument goes that at the very least, that will put a ceiling on prices.

Another major concern for oil watchers is what happens at the end of this deal. What, if you like, is the exit strategy ? Should we believe that in spirit of doing "whatever it takes", if producers are still battling with oversupply (as many believe they will be), the likes of Saudi Arabia and Russia will advocate extending and/or deepening the production cuts as necessary? You have to give the participants some credit for sticking to the agreed production levels pretty closely during this current deal, but frankly compliance with quotas is definitely NOT a strong area for OPEC and others historically. The suggestion that they will all be content to mothball oil fields and resist the urge to win back market-share indefinitely inspires little confidence.

Of course, if the measures do succeed then OPEC might not have to think about an exit strategy. As Gary Ross of PIRA Energy Group put it : "The exit strategy for OPEC is eventually, when the market is tight enough, start to cheat on the cuts".

OPEC won't thank him for expressing himself in those terms, but quietly they'll be happy enough if things pan out that way.