Editor's Note: This is an excerpt from an institutional note written by Senior Energy Analyst Joe McMonigle. For more information about our research contact sales@hedgeye.com.
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 a 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. In addition, for purposes of calculating the “cut” we have no indication what level will be used as the production baseline. Big difference between Saudi production in July of 10.67 million b/d and January’s 10.2 million b/d.
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. The OPEC formal statement was silent on the issue of exemptions but several ministers acknowledged it in comments to reporters. These three producers could provide a big 1 million b/d leaky hole in any OPEC production target ceiling.
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.
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.
