After chopping around for over three and a half years between $100 and $120 a barrel, with an occasional spike or two above, oil markets suddenly broke down two months ago, plunging violently through $100 to trade below $77 last week for a barrel of benchmark Brent oil.
That is at four year lows, and threatening to fall even lower.
*** Discussions are well underway within OPEC on output cuts aimed at putting a floor under oil prices if not reversing recent losses, and from what we understand, those production cut discussions are now being led, critically, by the Kingdom of Saudi Arabia. ***
*** The total OPEC production cut target under discussion we believe is just over 1 million barrels per day. An actual agreement on a cut, and one of this magnitude, would be more aggressive than markets expect, and bring current OPEC supply down from around 30.3 million bpd in October closer to OPEC’s estimate for the demand “call” on OPEC in 2015, which is 29.2 million bpd. The near term drop in demand is expected, however, to be even sharper than that – with the call on OPEC for Q1 2015 expected to be as low as 28.4 million bpd. ***
*** A deal is not finalized yet and may not come into place in time for the November 27 meeting of OPEC Ministers in Vienna. But negotiations are on-going to test the waters among members – and non-OPEC producers – for a production agreement that is credible and does not rely on KSA to carry the entire burden of cuts alone. ***
*** We believe negotiators may have a tentative green light for cuts from key members of the Gulf Cooperation Council OPEC countries (Kuwait, UAE, Qatar), and most critically KSA itself. They are looking for contributions or at a minimum, moral support, from non-OPEC countries. At the moment, they have received positive signals from Mexico and Russia, although whether these are for genuine output cuts or just words of support is not yet clear. ***
To Catch a Falling Knife
In the five months since its recent $115 highs of June 2014, Brent crude oil prices have plunged by almost one-third, to a low last week below $77.
OPEC, most notably Saudi Arabia, has nevertheless failed to respond to the collapse in prices through a cut-back in production. One narrative that has emerged in markets and among analysts to explain all or part of that failure is a deliberate plan by Saudi Arabia, the only real swing producer of the oil markets, to drive marginal competitors with higher oil extraction costs out of the markets through lower prices, particularly the booming fracking industry in the United States.
And KSA officials for their part are keen to present an unconcerned, tough message to the market — with huge financial reserves, its pain threshold is a lot lower than everyone else’s, so it can handle lower oil prices — while US Light Tight Oil (shale) investors will, for instance, be far quicker to shut in supply long before the Kingdom has to worry about its oil revenues.
But Riyadh is not as comfortable with falling oil prices as they may seek to appear.
That underlying discomfort with current prices is driving the quiet negotiations now actively underway within OPEC to reach an accord to stem the collapse in prices. Most importantly, Saudi Arabia appears to be now leading those discussions, albeit only if it can reach a deal that is on its own terms.
KSA officials realize that a headline number with no agreement on quotas would not be taken seriously by markets, and worse, could even backfire. But of course agreeing and abiding by quota agreements is always the hardest part.
Herding the Cats
Saudi Arabia is thus pressing hard for the highest level of burden sharing possible, but there is nevertheless a growing resignation to the reality that within OPEC the core of the cutting will need to be done by the GCC oil producers, even as others without the political or economic wherewithal to cut provide token support.
Given the speed and magnitude of the collapse in oil prices, OPEC members are attempting to bring non-OPEC producers on board with an agreement as well. A similar effort was achieved in response to the Asian crisis of 1999.
But some of those unwilling – or unable – to contribute the most are talking the loudest. Namely, for all its highly publicized recent shuttle diplomacy seeking OPEC consensus for a cut, Venezuela is on the verge of economic ruin and is not expected to be able to deliver much, even it was to promise to cut.
Iraq has been outside of the OPEC quota system for almost 25 years, since the first Gulf War of 1990-91 (how time flies), and Saudi officials do not seem to want to press the embattled new government of Haider al-Abadi, mired in its war with ISIS, for any substantial cuts. The same goes for Libya, mired in its own civil war.
And Iran has already seen its output collapse as a result of US-led Western sanctions. Tehran may be called to show at least some token support, but is not expected to be a major contributor to the oil output cuts. Nor is it clear what the contribution from Nigeria will be, or Angola and Algeria, but their contributions would be symbolic at best.
The burden will clearly fall on Saudi first and foremost then, and they will seek to at least spread some of that among the GCC oil producing countries, and perhaps even non-OPEC members.
Prices, Supply, and Demand
An agreement to cut oil production is likely to focus on stabilizing prices in the short-term, as Gulf oil ministers are keenly aware that any cut hands more market share to non-OPEC countries in the long-term. But the hope is that rising demand will also start to clean up excess inventory by the middle of next year.
And for all the downward revisions to global demand estimates, the Saudis do not see the demand outlook as quite so dire. Even as its economy is slowing, China’s oil imports have ticked higher, for instance, as Beijing seeks to take advantage of low prices to build inventories. And elsewhere in Asia, KSA sees oil demand as steady rather than sliding.
OPEC is also being advised by the International Energy Agency (IEA) that demand is not so weak and is being warned to be careful against over-tightening the market by cutting its oil output by too much – for what it’s worth.
And also for what it’s worth, the Saudis believe the market is heavily oversold and due for a correction higher anyway.
They can live with a lower oil price range but would like to see oil prices move back towards $100 over time. For now, they would be delighted if an agreement to cut oil output were to push prices back up to the $90-95 zone (Brent benchmark).
The risks to a cut, even if OPEC can agree to one, are nevertheless large.
Those clearly include over-tightening supply in the long run, further stimulating the development of alternative sources – but OPEC can deal with that problem if and when it appears.
In the short term the immediate risk, beyond a headline number perceived to be too low, would be a lack of compliance, and market credibility would suffer if an agreement were to fail to include a clear quota structure against which the market could assess performance.
The other key factor that could dent an agreement is high inventories. OECD stocks are likely to be shown to be above the five year average by the end of October, and Chinese strategic stock-building has been strong already this year.
Saudi Oil Minister Ali al-Naimi is therefore seeking a credible, and grand deal involving non-OPEC as well as OPEC member states, and that may take time, and perhaps even some more pain. The alternatives of no deal at all, or striking a quick, but weak, deal that the market may wish to test, could be far worse.
But those efforts points to a Saudi Arabia that is far from comfortable with, or much less actually condoning, a much more sustained drop in oil prices.