The Only Logical Time For OPEC To Start To Unwind The Cuts Is In July To Avoid Recreating A Surplus Problem
Dec 5, 2017
Before the end of Q1/18, we expect the market will turn its attention to how and when OPEC/non-OPEC exit from their cuts. The lower seasonal oil demand in Q1 should help keep oil prices from running away too high too quickly. Brent at $62.58 means the focus of the cuts is no longer how to get to $60, but how to manage to make sure a Brent >$60 is maintained without oil prices moving too high too fast. At the June review, we expect OPEC to make the case that the oil surplus will be gone before the winter 2018/2019, which sets up the ability to start to wind down the cuts on July 1. After all, this is the time of year when oil demand is always up seasonally every year. It is the only logical time of year for the cut barrels to be returned to the market without causing a problem. This timing should allow OPEC to manage an unwinding of the cuts and keeping Brent >$60 for the Saudi Aramco IPO, which in turn means WTI >$55 with the potential to look at a $60 base post termination of the cuts.
OPEC/non-OPEC agreed to extend cuts to Dec 31, 2018, but will review in June. On Nov 30, OPEC and non-OPEC agreed on a Declaration of Cooperation that had the expected 9-month extension to Dec 31, 2017, but also included a June review. The DOC said “in view of the uncertainties associated mainly with supply and, to some extent, demand growth it is intended that in June 2018, the opportunity of further adjustment actions will be considered based on prevailing market conditions and the progress achieved towards re-balancing of the oil market at that time”. Post Putin’s Oct 4 comments and the Saudi Crown Prince Oct 29 comments, the expectations were for a clean extension through 2018 without a June review. However, the market didn’t make a big deal of the June review. This extension thru 2018 but with a June review was in line with our OPEC predictions that we made in our BNN interview on Nov 29 [LINK].
The only logical time of year to start to exit from the cuts is the summer ie. July 1. A June review also just so happens to coincide with the one time of the year when a return of most of the cut barrels can be accommodated without going back to monthly surpluses. The one thing OPEC does not want to do is to stop the cuts, in whole or part, and then immediately start recreating the problem of oil stock surpluses. On Nov 16, Saudi oil minister al-Falih was asked about OPEC’s exit strategy and said “We will be very mindful when the agreement ends … so that we don’t enter a period of excess supply that builds inventories again,” [LINK]. That being the case, it means that the only time of year to do this or start this is the summer, when oil demand is always up strong on a seasonal basis every year. The higher seasonal oil demand can accommodate a return of oil supply. This is not a new concept. We wrote on this concept, including the reasons why, in our March 29, 2017 blog “Every Year Oil Demand Is Up In H2 Vs H1, Expecting +50 Million Barrels Per Month In H2/17” [LINK]. At tht time, we wrote “There is a strong logical case for oil hitting $60 before year end if OPEC/non-OPEC extend their ~1.8 million b/d and can manage reasonable (ie. >80%) compliance, even if US oil production continues to grow. Why? EVERY YEAR, oil demand is ALWAYS up strongly in H2 vs H1. Every year, oil demand follows a seasonal pattern. The low demand period every year is Q1. Then oil demand starts to pick up slightly in Q2, but the big increases in oil demand are every year in Q3 and Q4. Oil demand in H2 is expected +~1.7 million b/d, or ~50 million barrels per month of increased oil demand vs H1/17. “
Oil demand in Q3/18 expected up 1.2 to 1.4 mmb/d vs Q2/18. The below table shows the current Nov 2017 oil demand forecasts from the EIA Short Term Energy Outlook, IEA Oil Market Report, and OPEC Monthly Oil Market Report. The Q3/18 oil demand forecasts are higher than the Q2/18 demand forecasts by 0.7 mmb/d for the IEA, 1.2 mmb/d for the EIA, and 1.4 mmb/d for OPEC. We have focused on the EIA and OPEC because the IEA’s Nov forecasts tend to be too conservative. Our recent Nov 15, 2017 blog “Timely To Remember IEA’s Nov Oil Demand Forecasts Almost Always Turn Out To Be Lower Than Actuals” [LINK] noted this track record. We said “For the last 7 years, there has only been 1 year (2012) where the IEA’s early forecast for the out year hasn’t been too low. Looking specifically at the Nov forecast for the out year, the IEA’s Nov forecast was too low by 0.5 mmb/d in 2011, 0.8 mmb/d in 2013, 0.3 mmb/d in 2014, 1.0 mmb/d in 2015, 0.5 mmb/d in 2016, and 0.7 mmb/d in 2017. The only Nov OMR forecast that was too optimistic was in Nov 2012, where it was 0.8 mmb/d too high. The average of all years is >0.4 mmb/d”.
World Oil Demand (mmb/d)
Source: EIA, IEA, OPEC, Stream Asset Financial
In the June review, there should be visibility for the surplus to be eliminated. We also expect OPEC will likely be at or there will be visibility in the near term to eliminating the 140 mmb surplus to the 5-yr average as at Oct 31 by the time it reaches its June review period. That visibility will be helped by an easier target as the moving 5-yr average target will be increasing with the inclusion of 2017 into the 5-yr average. Bloomberg estimates [LINK] that this will lower the target by 35 mmb, or ¼ of the 140 mmb surplus as of Oct 31. The OPEC/non-OPEC Joint Ministerial Monitoring Committee (JMMC) Nov 29 statement [LINK] stated “From May to October, the OECD stock overhang fell by around 140 mb to stand at 140 mb above the five-year average in October”. The JMMC comments remind how the big reduction in the surplus happened from May to Oct, which is directly due to the seasonally higher oil demand every summer every year.
A Dec 31, 2018 end to the cuts effectively becomes an extension to March 31, 2019 for Russia. Russia was the wildcard going into the meetings as it is different from OPEC countries in that it isn’t a national oil company controlling all production, it is private oil companies like Rosneft. We believe it is tough for Russia to extend its cuts to Dec 31, 2018 because the cold winter temperatures in key producing Russian areas will effectively prevent a ramp up in production until Q2/19 ie. effectively extending the cuts to Russia to March 31, 2019. Also recall that Russia didn’t comply with the cuts until April due to the winter operating conditions. On Apr 28, 2017, Reuters [LINK] reported on comments from Russia Energy Minister Alexander Novak that “There will be a cut by 300,000 by the end of the month”, and Reuters also reported “Novak said that on average, Russian oil production declined by 254,000 bpd from April 1-26 compared with the reference level of October”.
The managing the cuts is no longer to get Brent to >$60, but to keep oil prices from running away. The focus or objective of the cuts is likely changing. OPEC did not set a formal price target for its cuts, but the broadly accepted view was that a Brent price >$60/b was the undeclared target and one that would provide a stable price for the Saudi Aramco IPO. Oil prices moved strongly in the run up to the Nov 30 meeting once the market believed in a 9-month extension. This started to happen on Oct 4. Russia has always been the one that markets expect wouldn’t agree to extend. But on Oct 4, Putin came out with his comments supporting the 9-month extension. WTI was $50 and Brent was $56, and the prices went up about $4 over the next couple weeks. Then on Oct 29, Saudi Crown Prince came out with his support for the 9-month extension. And both WTI and Brent went up another $3 or $4 thereafter. Brent closed today at $62.58 and WTI closed at $57.50. Now that the Brent >$60 has been achieved, we believe a new priority for the cuts is to make sure oil prices don’t run away too high, too fast and this increases the capital being delivered to short cycle US shale oil but also to other short cycle conventional oil projects around the world. We believe OPEC is resigned to the fact that US shale will grow by 0.87 mmb/d in 2018, but don’t want to see it over 1 mmb/d. That is why they don’t want oil prices to go up too high, too quickly and their biggest fear is that if WTI looks to be >$60, it could bring back a return of equity capital. Keeping a lid on oil prices will also helped by modest, if any, corrections to the oil surplus in Q1 with the lower winter oil demand.
Key OPEC/non-OPEC Events
Source: Bloomberg, Stream Asset Financial
If the cuts continue to be managed, investors will stop worrying about WTI dropping below $50 and more that a $60 base can be found. We believe the risk period for oil prices is Q1 when seasonal demand is the lowest in 2018 and that the correction to the oil stock surplus will be modest at best. We expect the June review to show visibility for the surplus to be eliminated, which will set the stage for the start to wind down of the cuts. The level of visibility will determine how much of the cuts are wound down at July 1. After all, the only logical time of the year to do this is in July when demand is always seasonally higher to ensure that the return of cut barrels can be accommodated without recreating the surplus problem. However, OPEC/non-OPEC can now focus on maintaining Brent above $60 (but not too high to quick) in the runup to the Saudi Aramco IPO. This means that WTI should be $55 or more and, most importantly, finding a view that a $60 base can be found. That is, unless there isn’t reasonable visibility in the June review that the surplus will be eliminated sometime prior to the winter 2018/2019.