OPEC could achieve its goal of eliminating the oil inventory surplus this month. But the goal posts will now move to another metric in order to justify keeping the production limits in place in order to drive prices higher.
As of February, the OECD commercial stocks stood at 2,841 million barrels, just 30 million barrels above the five-year average. That data came from the IEA’s April Oil Market Report, which publishes the inventory data on a two-month lag. Because we are largely looking through the rearview mirror at the inventory data, the stock surplus could be zeroed out this month, the IEA said, although we won’t know for a few more weeks.
The precise moment when inventories reach the five-year average – OPEC’s stated goal as part of its production cut agreement – is a bit beside the point. Whether it occurs in May or June doesn’t matter all that much. The most important thing is that the surplus is virtually eliminated, well before OPEC’s agreement is set to expire. Refined product stocks are actually already in a deficit relative to the five-year average.
The agreement was thought to last until the end of 2018, but that remains in flux. OPEC officials have signaled that they want to keep the cuts in place regardless of what the inventories are actually doing right now and that there is very little chance that the group takes action in June to phase out the agreement early. The coordinated cuts could even be extended into 2019.
But on what basis? Because the inventory metric will soon be obsolete, OPEC is scrambling for another justification. Earlier this year, the group hinted at a few possible alternatives. Perhaps the group could use the seven-year average for inventories instead of the five-year average. Presumably, that would require keeping the current cuts in place because the past seven years incorporates a period of time in which inventories were lower.
More recently, however, Saudi oil minister Khalid al-Falih has pointed to low levels of upstream investment. He argues that since the oil market downturn began in 2014, industry investment has cratered and has yet to bounce back in a major way. That is raising the odds that the oil market faces a supply crunch in a few years, a conclusion repeatedly echoed by the IEA.
Investment is the “most important metric” for evaluating next steps for OPEC, al-Falih recently said.
Still, it is interesting that the most powerful oil minister from within OPEC is pointing to investment levels as some sort of justification for keeping the current production cuts in place. Al-Falih says that by driving oil prices higher, it will stimulate more investment.
But one could be forgiven for questioning the motivation behind that. For one, investment levels, as a gauge of oil market health, is a rather subjective metric. At what level is spending sufficient? And when will we get there?
Second, it isn’t obvious that it is in OPEC’s interest to stimulate a ton of investment in non-OPEC supply. After all, OPEC has been ceding market share to other producers for a while now; it isn’t clear that stoking higher levels of shale drilling is really a good thing as far as OPEC is concerned.
Moreover, some analysts argue that the spending shortfall is overstated. “Over the next 10 years, we see that supply will continue to keep up with demand growth,” said Espen Erlingsen, an analyst at Rystad Energy, according to Bloomberg. “The surge in North American shale activity and start up of new fields are the main drivers for this growth.” Related: Iran Sanctions Could Throw Oil Markets Into Chaos
So, why talk about investment levels? Perhaps al-Falih is using oil industry spending as a pretext to keep the current production cuts in place to simply drive oil prices higher. Saudi Arabia has some very strong reasons to pursue higher prices, regardless of inventories or investment levels. The Kingdom wants to close a fiscal deficit and it also needs revenues for the economic diversification plan as part of its Vision 2030.
Most importantly, Saudi officials want higher prices ahead of the IPO of Saudi Aramco, tentatively scheduled for 2019. Exiting the OPEC cuts would pose a serious risk to oil prices, even if inventories are indeed back at average levels.
As such, it is very useful for Saudi Arabia to pivot to oil industry investment levels as a justification for keeping the production cuts in place. Oil prices will drift higher as inventories dip below average levels and the market grows tighter. For other OPEC members, higher oil prices also shower them with more cash, so no harm in going along. Keeping barrels offline does require a sacrifice, but prices have shot up over the past year, more than offsetting the pain of restricting supply. There is a long-term risk – sparking too much rival non-OPEC supply. But for now, OPEC is playing for the short-term gain.
“Talking about the need for more investment is a way of saying: ‘Hey, world, we’re OPEC and we want higher prices, but we’re actually doing you a favor’,” Mike Wittner, head of oil market research at Societe Generale SA, told Bloomberg. “In the end, it’s about revenues.”
By Nick Cunningham of Oilprice.com
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