After failing to agree to a production freeze in Algiers, OPEC went to its “Break Glass in Case of Emergency” box Wednesday and said it would try for a revised “production target” when the group convenes again on November 30 in Vienna.
Faced with the prospects of price decline for not meeting self-imposed expectations of a freeze accord, OPEC said in a statement it “opted for an OPEC-14 production target ranging between 32.5 and 33.0 million barrels a day (b/d).” The 32.5 million b/d number was selected because it represents OPEC’s own forecast demand for its crude in 2017.
OPEC hopes the market will view that a deal to agree to a deal in the future is a deal. Oil was up about 5% on Wednesday but it remains unclear if that sentiment can be maintained after a closer examination of this shaky strategy.
Our preference would have been for OPEC to take its lumps on price after not getting a deal and instead say the talks had made significant progress and laid the foundation for a productive meeting in November. Now we fear the “production target” strategy has only supersized expectations for the November 30 Vienna meeting and created more risk and uncertainty for the market.
Nonetheless, OPEC has stated its goal of a “production target” in order to “accelerate the ongoing drawdown for the stock overhang and bring the rebalancing forward.” The “how” remains a difficult challenge. It is the reason why a freeze deal was not achieved this week. As a result, we believe the path out of Algiers is on thin ice and provide the following rationale for why we are not optimistic about the chances for success.
First, the significant delta of 500,000 b/d between the stated production target range of 32.5 and 33.0 million b/d should not inspire confidence. OPEC’s own source estimates for August production of 33.25 million b/d and forecast 2017 crude demand of 32.5 million b/d implies a production cut of nearly 750,000 b/d. If the target is closer to 33.0 million b/d, the implied cut is a paltry 250,000 b/d. In addition, for purposes of calculating the “cut” we have no indication what level will be used as the production baseline. For example, Saudi Arabia produced 10.67 million b/d in July but its production seasonally declines in January to about 10.2 million b/d. Is that really a cut if the Saudis were going to reduce production in a few months anyway? Using a January baseline would suggest a more serious proposal but seems unlikely Saudi Arabia would cut that much.
Second, the OPEC President told reporters at a press conference Wednesday that the start date and duration of the revised production target are yet to be decided. The most common terms we have heard are for an effective date of January 1 and a one-year duration. But Iraq has said recently that it can only agree to a duration period of several months.
Perhaps the biggest hole in the production target “deal” is that there will be no actual production constraints on Iran, Libya and Nigeria. That’s right. Saudi Energy Minister al-Falih told reporters in Algiers that Iran, Nigeria and Libya would be allowed to produce “at maximum levels that make sense” as part of any output agreement. The “make sense” language may be qualifying on his part but for those producers it will be viewed much differently. Iran says it wants to get back to pre-sanctions levels. This could result in another 150,000 to 400,000 b/d increase depending on Iran’s current production level. Nigeria and Libya could soon both add a combined 800,000 b/d in production. These three producers could provide a big 1 million b/d leaky hole in any OPEC production target ceiling.
OPEC’s formal statement released on Wednesday is silent about any exemptions for countries to participate in the production ceiling. The statement did say that OPEC would form a committee “to study and recommend the implementation of the production level of the Member Countries.” Good luck with that.
The committee will also hold discussions with non-OPEC producers about cooperating with a limit on production. Russia has been a leading proponent for a production freeze but there are real doubts about its willingness or ability to reduce production. First, Russia’s major oil companies are publicly owned and have western oil company partners. It’s not at all clear that President Putin can command or that companies can logistically comply to reduce or limit production. Also, Russia is not really dependable on such matters. In 2001, Russia agreed to an output limit with OPEC but then cheated and actually raised production.
Return to OPEC supply management to boost prices may create a lifeline to US shale producers. US crude production today is about 600,000 b/d less than one year ago. New Iranian production this year since nuclear sanctions were lifted have just replaced the declines in US production. If prices rise above $50, US shale producers may end up replacing any OPEC decline from a production ceiling. It will be difficult to rebalance the market if US shale production starts rising prematurely.
Shift in Saudi Assessment of Market Conditions
In a May note to clients previewing the spring OPEC meeting, we said that the upcoming November 30 meeting could be the first time in two years that a change in OPEC and Saudi production policy would be under serious consideration. In a subsequent note on the June 2 meeting, we reported from Vienna that we believed the Saudis had sent signals to other OPEC members that they were open to a change in production policy.
In both notes we said market conditions in the fall would guide the Saudi thinking about potentially changing their production policy. In particular, we said declining US production was a key barometer for the Saudis as well as continued cap-ex cuts.
EIA weekly data released Wednesday showed another decline in US production, and just last week Total announced another $3 billion cap-ex cut and further project delays for 2017.
We are planning a trip to the region to make a better assessment but it appears now that Saudi Arabia has determined the conditions may be ripe to consider making a change. Since early summer, Saudi Energy Minister al-Filah has expressed that the Kingdom sees evidence the market is slowly coming into balance. Moreover, he has also said that global investment cuts in the sector could result in a supply shortage in the next few years. Another element to Saudi thinking is that the only area left for demand growth is in producer countries. Therefore, higher revenues to national producers will boost sorely needed economic growth and result in increased global demand.
We know the early return of US shale production is a significant concern to the Saudis but they also believe that it will take at least a year for US producers to regain previous levels and assume demand will also be higher in turn.
Certainly market conditions could change between now and November 30. Plus we do not believe the Saudis will want to forfeit any market share to Iran. As a result many thorny issues lie ahead that present real challenges to achieving a revised “production target” in November.
