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Why An OPEC Deal Extension Won’t Lift Oil Prices

Anadarko rig

Oil prices rallied more than 4 percent over the past week on rising expectations of an extension of the OPEC deal. Kuwait and several other OPEC members voiced support for an extension and a growing number of analysts see an extension as likely. Some experts even think OPEC has no choice but to roll over the cuts for another six months.

But the IEA threw cold water on the notion that an extension would lead to higher oil prices. The IEA’s executive director Fatih Birol told Reuters last week that keeping the cuts of 1.2 million barrels per day in place for another six months might not resolve the supply problem this year.

“There is a tremendous amount of stock in the markets and to expect a major increase in the price is not very realistic," Birol said. U.S. crude stocks still stand at a record high and even if they begin to come down it will take an extended period of time to bring them back in line with more typical levels.

But aside from the inventory problem, the IEA says that any price increase would simply spark new supply, a development that would quickly bring prices right back down. That echoes a call from Goldman Sachs, which has maintained that the OPEC cuts will not engineer higher prices. Goldman went further recently, saying that even extending the cuts might be self-defeating. Goldman says an extension beyond June is not necessary and is probably ill-advised.

The IEA argues that it isn’t just a U.S. shale problem. Supply is set to come online from other non-OPEC producers, namely, Brazil and Canada.

"If we see the prices go up as a result of any push from the producers ... we will see more oil coming to the market, not just from the U.S.; we will also see Brazilian and Canadian oil coming to the market." Related: What Is Putin Planning For Ukraine?

But Mr. Birol might have misspoke. The IEA has projected increases in output from Brazil and Canada this year, regardless of whether or not prices go up in response to OPEC. Canada could add around 150,000 bpd this year, new supply coming from projects that began years ago. New oil sands projects are not exactly viable in today’s market, but Canadian producers are still finishing up projects started in the pre-2014, $100 oil environment. Over the next five years, Canada will add nearly 1 million barrels per day.

Brazil could be a larger headache for the oil market. Pre-salt projects are finishing up and could add 230,000 bpd this year. Brazil will add around 1.1 mb/d over the next five years, the IEA predicts. Unlike Canada, Brazil could have a much larger upside as its massive offshore reserves are still largely undeveloped. More importantly, after years of state ownership, Brazil’s offshore is enjoying a wave of interest from oil majors – particularly Royal Dutch Shell – after the government privatized and liberalized the sector last year.

So, some of the new supply from Canada and Brazil is coming whether the oil market is prepared for it or not.

New shale supply from the U.S. will be much more contingent on short-term fluctuations in oil prices. And those price movements will depend on what OPEC does in May. Related: Maduro’s Last Stand: Military Takes Over Struggling Oil Sector

Despite the newfound optimism from oil traders regarding OPEC’s resolve, the cartel will play it close to the vest until the last minute. OPEC members have an interest in being cagey, as each will hold out support for a deal in order to exact concessions, as Ellen R. Wald argues in a recent article on Investing.com. Saudi Arabia will likely withhold support for a deal in order to pressure lagging OPEC members, threatening them with lower prices unless they step up. Russia too could scuttle an extension if it backs away from cooperation, and the threat of such an outcome grants them leverage in negotiations. The same is true for Saudi Arabia vis-à-vis Russia.

In the meantime, as is often the case, OPEC will try to jawbone the market, offering investors morsels of confidence in order to talk up oil prices. But little will be known for certain until May.

That won’t stop the market from hanging on their every word. For now, hopes are rising that an extension will be agreed to, pushing WTI back up above $50 per barrel.

By Nick Cunningham of Oilprice.com

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