OPEC is about to extend its production cuts for another nine months in an effort to bring the oil market back into balance. Keeping in place the 1.2 million barrels per day (mb/d) of OPEC cuts, plus the 558,000 bpd of non-OPEC reductions, for nine months rather than six should be enough to “normalize” crude oil inventories, according to most analysts.
Great. Mission Accomplished. By the end of the first quarter of 2018, the market will have tightened and OPEC members can go back to producing as they were before, producing as much as possible and fighting for market share.
But here’s the thing. When the deal expires and OPEC members open up the spigots again, it could create another glut just as before. That is the warning from a new Goldman Sachs report, which says that the oil market could find itself once again awash in oil in the second half of 2018 after the expiration of the OPEC deal. “[W]e see risks for a renewed surplus later next year if OPEC and Russia’s production rises to their expanding capacity and shale grows at an unbridled rate,” Goldman analysts wrote in the research note.
While the extension of the OPEC cuts will succeed in bringing down inventories to normal levels over the next nine months, the problem is that oil production capacity continues to grow both within and outside of OPEC. Everyone knows the story of surging U.S. shale – drillers are coming back quickly, having achieved lower and lower breakeven costs over the past several years. Energy watchers are having to repeatedly revise up their forecasts for shale growth. The EIA says that shale production will grow by more than 800,000 bpd this year, with an annual average output of 9.3 mb/d in 2017 and a staggering 10.0 mb/d in 2018. Related: Will This Miracle Material End All Energy Storage Problems?
But it isn’t just U.S. shale that is going to grow between now and the end of the OPEC deal in March 2018. Canada and Brazil are both bringing new large projects online, and could together add more than 400,000 bpd this year. Russia is investing in new production capacity in the Arctic and the country’s output hit a record level just before the OPEC deal went into effect. Kazakhstan, a non-OPEC country that, like Russia, is party to the OPEC deal, has failed to comply with its commitments because it has oil fields in the Caspian that are ramping up.
Even within OPEC, there will be rising supplies. Iraq is targeting 5 million barrels per day of production capacity this year, sharply higher than its promised cap as part of the OPEC deal at 4.35 mb/d. Libya is aiming to add another 500,000 bpd or so to bring production up to 1.2 mb/d later this year. Saudi Arabia has also stepped up its rig count over the past year with an eye on long-term growth.
In short, despite $50 oil and upstream investment levels still a fraction of pre-2014 levels, supply is still growing. That means that when the OPEC deal expires, and everyone goes back to producing as before, the surplus will return. The OPEC cuts only work so long as they are in place.
However, all is not lost. Goldman Sachs suggests that OPEC has one tool at its disposal: bending the futures curve into backwardation, which is when near-term oil contracts trade at a premium to futures dated much further out into the future. How can OPEC do this? Basically, if OPEC can signal that the market will tighten this year (by extending the cuts) while also simultaneously signaling that their output will increase once inventories normalize, they can provide a jolt to near-term oil prices while at the same time push down oil futures for 2018 and beyond. Related: Can Private Investment Turn Mexico’s Ailing Oil Industry Around?
Why would this matter? By lowering the prices of longer-dated oil futures relative to today’s prices, OPEC could try to derail shale growth, for several reasons. For shale drillers, it will make hedging more difficult, because companies will have to lock in next year’s production at lower prices if they really want to hedge. A downward sloping futures curve would also lower the stock prices of shale drillers since lower future prices will mean the companies are worth less. It will also jack up the cost of debt as lenders grow wary.
In short, flipping the market into backwardation would starve shale drillers of finance. “[T]he binding force to sustainably slow shale growth lies on the funding side and we believe that sustained backwardation can restrain access to the large pools of private equity and [high yield] credit capital,” Goldman wrote.
By Nick Cunningham, Oilprice.com
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