Oil bulls were unhappy with yesterday’s OPEC announcement, which disappointed by adding nothing to the 9 month supply cut extension announcement which had already been leaked and largely priced in while leaving key questions unanswered, including what it has planned for the long-term.
The broader Wall Street commentary was similarly downbeat: “To say that yesterday’s performance was disappointing for bulls is an understatement,” Tamas Varga, analyst at PVM Oil Associates wrote in an emailed report. “It is, however, not a foregone conclusion that the trend is definitely turning. The question now is whether yesterday’s sharp drop in oil prices was a panic long-liquidation or the technical picture is now firmly turning bearish.”
Barclay’s analyst Michael Cohen captured the mood best with a note overnight titled “No light at the end of the tunnel:, in which he writes that “OPEC and several non-OPEC countries finalized plans to extend production cuts for an additional nine months (through Q1 2018) without specifically articulating an exit strategy. During the press conference, Saudi Energy Minister Khalid Al-Falih expressed confidence in the plan to extend the cuts through Q1 2018, saying that inventories would fall below the five-year average before year-end, but cuts should remain in place during Q1 2018 due to seasonal demand weakness, which we highlighted yesterday (OPEC’s Vienna Meeting: Intermission, May 24, 2017). By our calculations, if half of the supply deficit is applied to OECD stocks, we do not see the inventory level approaching the five-year average by this timeframe.“
This is exactly what we warned about in “The Math Behind OPEC’s Revised Production Cut Still Does Not Work.”
Below we excerpt some other of the key highlights from MS, which was clearly soured on the outlook for oil prices after OPEC’s meeting:
- OPEC may still be underestimating shale. Saudi Oil Minister Khalid Al-Falih made several comments that highlighted an interpretation contrary to our thinking about the state of the US shale industry.
- Cost inflation is not yet an issue for US E&Ps. The first comment related to “significant cost inflation” that has hit the industry this year. This belief runs counter to reports from many US E&Ps and the oilfield service companies during their Q1 earnings calls (Figure 3). Those that are experiencing cost inflation have been able to mitigate total well costs through further efficiency gains.
- Most US E&Ps are still drilling their core acreage. The second comment was that as activity ramps up, producers are moving into more expensive shales, which runs counter to E&P reports that the industry has several years of tier 1 (low breakeven) drilling inventory.
- The US oil and gas sector is focused on growth and will slow when prices dictate. The third comment related to a “hope” that shale producers would moderate production. US E&Ps will moderate activity only if prices constrain activity. At current price levels, many producers will continue to meet or exceed their 2017 production guidance.
- The extension should afford some price stability over the next nine months, allowing US producers to move forward with 2017 and even 2018 development plans. During Q1 2017, many E&Ps used $50 oil to provide guidance for 2017. In our view, producers will not diverge from guidance unless prices are significantly below this level ($40-45) for a sustained period.
- The JMMC will monitor country production levels and recommended adjustments if necessary. As we highlighted yesterday, the JMMC is the new mechanism to make recommendations and will be meeting on a bi-monthly basis to discuss the progress of the deal. This new function adds additional uncertainty to what balances will look like over the coming months. If prices fall or rise too much, the JMMC may propose actions to re-stabilize prices.
- The recasting of a new producer group, “NOPEC,” which includes 24 countries that account for around 60% of production. Russian energy minister Novak and Saudi Minister Al Falih took pains to highlight that through regular interaction the group can promote “healthy markets.” Furthermore, the countries are “better poised to approach challenges that might lie ahead.”
- Equatorial Guinea has joined OPEC. This will end up being an accounting change. We expect its almost 300 kb/d of output to decline next year.
Next, Barclays’ implications and outlook:
Market balance implications: If OPEC is taken at its word and maintains 100% compliance over the summer, the balances would likely be 500-600 kb/d tighter than what we currently assume, and this would coincide with an inventory draw that presents upside risk to our $56/b forecast in 2H17 and 1Q18 and downside risk to our forecast in the remainder of 2018 assuming no further changes to OPEC output. For now, we maintain our forecast, as other prevailing factors would likely offset further oil price appreciation, such as accelerated US tight oil growth and demand destruction that would occur as prices increase. We will publish an update to our comprehensive market balance in our upcoming Blue Drum monthly publication. We are already calling for US liquids production to grow 1.2 mb/d from Q4 2016 to Q4 2017 and an additional 1 mb/d from Q4 2017 to Q4 2018. With this agreement, there is scope for output to move even higher over the next 18 months.
The implication of OPEC’s action creates a situation that will force it gradually to exit its market management mode. Minister Al Falih tried to assuage fears that it has an exit strategy in mind by saying it will cross that bridge when it comes to it in November 2017 and next year. In our view, the more accelerated declines we will see in stocks in the coming quarters and the floor OPEC has provided for the coming nine months are likely to result in aggressive growth in US tight oil, which we are already forecasting, and OPEC is likely to struggle to find a big enough hole to fit its incremental supply, keeping the proverbial light at the end of the tunnel out of reach for longer than just the first quarter of 2018.
* * *
Separately, in a just as disappointed note released overnight by another recent oil bull, Morgan Stanley’s Martijn Rats, the commodity analyst echoed what Goldman said yesterday, and lowered its year end oil price forecast from $60 to $55 because while “OPEC’s extended cut will likely lead to stock draws in 2Q/3Q and provide some oil price support, when this agreement ends, and coincides with strong shale growth, the market looks oversupplied again. This has become our expectation for 2018, and we lower price forecasts as a result.“
OPEC chooses the lesser of two evils: In recent weeks, OPEC found itself faced with a difficult choice: extend the production cuts to bring down bloated inventories, or end the cuts to prevent further loss of market share. The experience of the 1980s has shown that the latter can become as problematic as the former. Clearly, OPEC decided for the former, but it is storing up problems for 2018, in our view.
Near-term we see inventories drawing and providing support for oil prices: Global oil inventories finally started drawing in March, at a rate of ~0.9 mb/d based on monthly data. Weekly data suggests this has continued in April and May. With demand getting a seasonal tailwind, and OPEC extending its cuts, we expect inventory draws to accelerate in 3Q. Altogether, we estimate that global stocks will fall by ~100 million bbl in the balance of the year. Although these draws are smaller and are coming later than we once expected, this should nevertheless provide some price support in coming months. We forecast WTI to end 2017 at $55/bbl, down from our previous forecast of $60/bbl.
But the outlook for 2018 is starting to look troublesome – End of OPEC agreement + Strong shale growth = Loose market: We do not expect that OPEC will extend its output cuts much beyond 1Q. By historical standards, that would be an unusually long period of output restraint. However, non-OPEC production has already returned to year-on-year growth and is set to accelerate in 2018, driven by shale. When the end of the OPEC production cuts meet strong shale growth, the market is almost certainly oversupplied again. As a result, we lower our end-2018 WTI price forecast to $55/bbl, from $60/bbl before, although we could still see lower prices at some point during 2018.
All of this has implications for long-term prices too: Our previous long-term price forecast of ~$70/bbl for WTI by 2019/20 was based on our estimate that ~1.5 mb/d of 2020 demand would need to be supplied by projects that have not been sanctioned yet, but that have break-even oil prices around that level. However, with stronger shale growth, slightly weaker demand and some additional cost deflation, the reliance on this 1.5 mb/d has almost entirely been wiped out. We still see 1.6 mb/d of 2020 demand that needs to come from projects with break-evens of $55-65/bbl, so we lower our end-2020 WTI forecast to $60/bbl.
How long until OPEC is back to the drawing board, or at least jawboning, of even more cuts, and even longer production halts? The answer: not long at all, as this hit moments ago from Reuters:
- RUSSIA’S NOVAK SAYS OPEC+ MONITORING COMMITTEE MAY DISCUSS POSSIBILITY OF ADJUSTING GLOBAL OIL OUTPUT CUT DEAL IN JULY