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Stuart Parnell

Stuart Parnell

Stuart Parnell is a managing director in Stormont Energy Advisors In addition to deal origination and M&A transaction management, Stuart focuses on the financial side…

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How Much Will Inventories Shrink As OPEC Extends Cuts?

Well, if it’s the end of May, it must be time for another OPEC meeting. And sure enough it was. Yet again, the representatives of the OPEC nations got together in beautiful Vienna (I hear it’s tremendous in the spring) to decide the future of the oil industry and set the course for everyone’s favourite and most hated commodity for the next few hours, days, weeks and months. Joining the OPEC flashmob this time were members of the non-OPEC nations who were participating in the first round of production rollbacks agreed to last November.

At issue: so, we agreed to these cuts, and the price went up but those tight oil guys are making swiss cheese out of the West Texas desert and lately the market seems to be slipping. What next?

What did they decide?

Before we get to that answer, let’s do a quick review of where we are at. OPEC and NOPEC (as it’s now being called – I kid you not) collectively agreed to roll back production on a formula basis by about 1.8 million barrels per day for a six-month period, due to expire June 30 of 2017. Compliance has generally been stellar, which is unusual, and anecdotal evidence suggests that the cuts are slowly working to rebalance the oil production/supply/inventory situation. Slowly of course doesn’t work for jittery markets that need immediate gratification so perversely, the longer the cuts are in place, the less effective they appear to become. Meanwhile, at around $50 oil, the U.S. tight oil industry has been adding rigs like they are going out of style, hedging production at high prices and drilling like mad. The same of course is happening in Canada to a lesser extent.

So, what did they decide anyway? It’s not secret, everyone knew last week when Russia and the Saudis pre-announced the decision, but for the record, the agreement was to extend the cuts for another 9 months, continue to exempt Libya, Nigeria and, to a lesser extent, Iran. This was called by the media the “safe option” for some bizarre reason, because, you know, holding back a cumulative 800 million some odd barrels from the market is clearly the “safe” play for a bunch of countries that rely on oil revenues to placate their restive populations.

No, far from being safe, what OPEC/NOPEC did was acknowledge that the inventory draw-down was taking longer than expected and by setting the target so far out, they eliminate a lot of the uncertainty and quarterly speculation from the market. Many analysts in the last few days had been speculating that OPEC/NOPEC needed to actually cut even more to address the inventory, but this was never a realistic idea given how compliance issues would become greater with higher cuts and the fact that the 800 million barrels in cuts for exceeds what every self-respecting analyst acknowledges to be the actual inventory overhang.

What did the market do?

Predictably, when confronted by stability, commitment to support prices and a credible plan to get there, the market sold off oil by more than 5 percent. For all intents and purposes, this appears to have been a purely speculative market move with a lot of short covering and people selling out of long positions purchased as a bet on additional cuts. The market had bid itself up by almost an equivalent amount in anticipation of the meeting. I’m actually inclined to say the run-up to the meeting was more surprising than the post announcement sell-off but all quite predictable.

How long will it last?

I would expect the cuts to last nine months.

No really, how long will it last?

Seriously, nine months. Maybe longer. The real question, of course, is not how long the announced cuts will remain in place, but how long can this herd of cats be kept in compliance with the cuts? The simple answer is that as long as the cuts are supportive of prices and data starts to finally flow regarding a significant draw-down in inventory the various members of the OPEC/NOPEC output cut team will play the compliance game. Resolve and discipline will falter in a scenario where prices spike or fall considerably.

Related : Private Equity Is Jumping Into This Reemerging Oil Hotspot

How will we finally know the cuts are working?

We know the cuts are working when the OECD monthly storage numbers start reflecting the expected declines in inventory. Already the IEA stats have shown that “additions” to OECD inventories have slowed significantly signifying a coming supply/consumption balance. But remember, we are trying to eliminate an overhang of about 500 million barrels, this takes time!

Price is a decent signal about the cuts working, but price is driven too much by sentiment.

If you prefer your data to be, I don’t know, current… one good place to look would be the weekly import numbers into the United States as reported by the EIA. If you see imports from Saudi Arabia and Iraq (among others) start to drop in these numbers, we are on to something. The Saudi oil minister in fact said this himself, telling the market that Saudi exports to the U.S. were going to be reduced.

But all the above aside, the cuts are already working.

Why not cut more like everyone seems to want?

As per the above comment about discipline, if the cuts are too deep a number of things happen. First, prices will rise too much creating a temptation to cheat. Second, the incentive to drill becomes stronger for those producers not part of the cut, which means the sacrifice is even more unbalanced creating a further temptation to cheat. Finally, and I think this is overlooked by the genius analysts and market commentators, when prices rise, the end products (i.e. gasoline) get more expensive which dampens demand, upsetting the other side of the equation. Could OPEC/NOPEC have cut more? Sure, but it probably wouldn’t make much of a difference. Mathematically, the current cuts will work. I call it the “Goldilocks” scenario – not too hot, not too cold. Let it play out.

Does this mean U.S. inventories will finally start to shrink dramatically?

It is expected U.S. inventories will continue to drop as they do every year at this time (7 weeks in a row and counting), but it probably won’t be overly dramatic.

Um, what?

Well, ironically, U.S. inventories are probably the last place where you should look to assess the success of OPEC/NOPEC production cuts. There are a few reasons for this. First, the U.S. supplies about 60 percent of its daily liquids production needs. Second, the balance comes from imports, the majority of course from Canada who isn’t part of NOPEC, so a decrease in OPEC imports into the U.S. can be made up in the short term from Canada. Finally, storage in Cushing, the continental U.S. and many OECD locales is the cheapest in the world. So, all things being equal, you drain the most expensive storage first. By the time big drops start appearing in the U.S., the inventory depletion will be in full gear and the worry will be that this has all gone too far. I’m willing to place a bet on that. Anyone? Anyone?

What are risks to price in the short term?

Short term price risks appear to be mostly market driven. Perception, boredom, hype. OPEC/NOPEC has set a floor under prices. Other risks to keep an eye on are demand signals from China and India and of course the ever-present price bogeyman of U.S. tight oil. I suppose these are all downside risks. Upside price shocks would come from a rapid decline in inventories (let’s not forget depletion too!) or some form of increased hostilities either on the Korean Peninsula or the Middle East.

What does this mean for tight oil?

I think it means more of the same. They will continue to drill but in the Goldilocks pricing environment we are currently in, things are getting tight in Texas. Latest data suggests the drilling boom is coming up against some labour and equipment constraints with prices up 10-15 percent, capex being left unspent because of lack of resources and break-evens creeping by $3 to $5 a barrel (say it ain’t so!). At the same time, recent data out of the EIA shows that drilling productivity has a hit a bit of a speed bump and declined in the latest reporting period. One measurement isn’t a trend, but the engine light just came on, time for a checkup. At The end of the day, U.S. tight oil is going to grow, the question is just how much can it actually grow given the realities on the ground in Midland as opposed to a corner office in Manhattan.

What does it mean for Canada?

Much the same as the U.S. tight oil scenario, the current pricing scenario sets the stage for slow and steady growth in some of Canada’s most appealing plays and increased royalties into provincial coffers. As long as we can stop shooting ourselves in the foot from a regulatory standpoint, Canada should see steady growth in the energy sector over the next few years. Related: Iran Signs Oil For Goods Deal With Russia: Breaks Free Of Petrodollar

Why is backwardation important?

Mainly because it’s a really cool word and easier to say without laughing than contango. Seriously though, backwardation is a situation where the spot and close-in price of a commodity is higher than the forward price. In this scenario, there is less incentive to store a product for later sale than to sell it immediately. While this is a bullish signal for inventory depletion, it is also an incentive to increase short term production (i.e. tight oil) so it kind of kicks the can down the road. That said, it’s a net positive for dealing with the current oversupply situation.

I hear Donald Trump is going to flood the market by selling half the Strategic Petroleum Reserve, isn’t that going to send prices spiraling?

No, not really. First, the U.S. government is already selling some of the SPR. Second, the proposed budget provision to sell off some 300 million barrels of oil is a longer-term proposition and isn’t going to even generate much cash in a multi-trillion-dollar budget. Not a fully formed or well thought-out idea and it has a low likelihood of happening.

Plus, even if it does happen, the planned sale is over a number of years and amounts to about 95,000 barrels of oil a day. Not enough to move a market.

By Stormont Energy Advisors

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  • Alex on May 30 2017 said:
    By far the best article on the OPEC deal I have read so gar. Realistic and thoughtful.

    Thank you alot!

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