So, let me start this week’s column with a frank admission: I was wrong. Well, not totally. I gave the possibility of an OPEC freeze less than a 20% chance of getting done. And frankly, I’m flabbergasted that they have an agreement. Sorta of. In principal. Although even as of last night, we might already see some fault lines developing….
So, while I am extremely excited about the possibility of a production freeze, I must issue you all a few words of caution.
First, we have, as we lawyers say, an agreement to agree. And legally, an agreement to agree is just that, a nonbinding resolution between the parties that is not a contract. Until a formal contract is made, there is no agreement and a court cannot enforce it. Now, that analogy is a little bit flawed because Nations that are mere members of a cartel are never truly legally bound. But I want to point out that we do not have a real agreement – just an agreement that these will be the targets for all of OPEC at the next meeting and between now and then (or at the meeting) they will figure the rest out.
This is particularly true given that certain countries appear to be exempted from the freeze requirement. How can you have a production freeze yet simultaneously tell at least 3 members: you guys do whatever you want…. That doesn’t make sense. The devil is in the details, and those details will have to be hammered out over the next several months. The hard work has not yet done.
This caution aside, the agreement is still significant. As I spoke about in earlier editions, OPEC is in jeopardy of losing credibility if they continue to allow oil markets to fluctuate and refuse to exercise their discretionary power to help return the markets to stability. This is particularly true after various members made public statements supporting some action and their multiple failures thus far to reach agreement. If they announce this freeze and then do not follow through, their ability to manipulate markets in the future may be compromised.
Remember, also one of the main problems (among many) originates from the inherent conflict between Iran and Saudi Arabia, two regional arch rivals (philosophically/religiously, economically, and militarily). According to several sources, Iran wanted to ramp up to 4.1-4.2 million bpd, effectively 12.7% of the Group’s total production – which is what Iran was extracting as a percentage before the 2012 sanctions. In contrast, Saudi Arabia wanted Iran to hold current production levels. This represents a substantial compromise by Saudi Arabia. Will they actually be able to live with it if Iran produces more than they expect.
But yesterday, Reuters reported on a new wrinkle: Iraq. As Reuters noted, for years Iraq has been happy to sit on the sidelines and sort of stay out of the battle between Iran and Saudi Arabia. But now, Iraq has overtaken Iran as the cartel’s second largest producer, they want more input. Iraq's new oil minister Jabar Ali al-Luaibi has already said he does not like an output ceiling of 32.5 million barrels per day arguing that OPEC has dramatically underestimated Iraq’s capacity. So, now you start to see some of the politics going into an ultimate deal.
Which brings up another problem: adherence. We have all seen how well OPEC does at adhering to their own quotas…. If Iran starts pumping, will the Saudis sit on the sidelines?
I also want to point out the level at which output was frozen. The freeze will effectively put OPEC at levels not seen since early-mid 2014. (If you want to see OPEC’s historic monthly production, click here. For data purposes, in June 2014 OPEC production was 32.77M, pre-summer production this year was around 34.5M, and June topped a whopping 35.1M (as the Saudis and other Middle Eastern countries increased production to keep up with increased internal electrical usage). This is according to OPEC’s own monthly report!!! So I’m not sure where they get their 33.24 million bopd number from.
Remember, in the last of edition of the Five Star Standard, we reported that the revised EIA report noted that, “The pace of inventory builds is expected to slow to an average of 0.8 million b/d in 2016. Inventory builds are expected to continue into early 2017, and then consistent inventory draws are forecast to begin in June 2017.”
So this is a significant decrease. But the other issue is the pent up oil wishing desperately to be released from storage tanks around the world. Let’s just assume for simplicity that oil is expected to build at about 400,000 barrels per day in Q3 2016, with that gap slowly narrowing (as the EIA recently projected). A production cut of approximately 750,000 barrels is significant. This will be in addition to the natural decline we can continue to expect to see from CAPEX reductions. So assuming other producers do not jump into to fill the gap (a big assumption), this is a significant reduction. But bear in mind, that U.S. storage stood at an estimated 502.7 million barrels according to the EIA this week and total worldwide liquid fuel in storage was recently estimated to be about 3.00 billion barrels (or about 66 days supply). So, this reduction, while meaningful because it brings supply and demand back into balance (presumptively) doesn’t mean we will see a rapid market change as we have a whole lot of storage we need to eat through. It is estimated that a 1 million barrel freeze would have reduced stocks by 290-330 million barrels over the course of a year, even if U.S. Production started to recover.
Now that OPEC has announced their intention to freeze, I believe the chances are reversed and we now have an 80% or greater likelihood of a finalized agreement. Adherence? Let’s hope. The one bright spot is that the Saudi’s have rapidly eaten through their foreign currency reserves. So the Saudis do have some incentive to actually get the deal done and actually adhere to it. Saudi Arabia has burned through -$182 billion of reserve assets since Aug 2014. Official reserve assets have fallen by -24% from $746 billion to $564 billion. Reserves assets fell -$52 billion in the first seven months of 2016.
And Iran does as well. Iran needs a deal slightly less than Saudi Arabia to balance the budget. The IMF says the Saudis need oil close to $67 a barrel to square the books. For Iran, it’s lower, at $61.50. But it still needs a lot more than current oil prices: and that is without achieving some of its goals.
So, assuming the deal goes through, what happens? Goldman Sachs Group Inc. said the deal to cut output could add as much as $10 a barrel to oil prices, though it remains skeptical along with other banks on how the accord will be implemented.
After that, I think you will see a slow recovery in the U.S. shale market. I don’t think you will see a quick recovery but assuming a deal is finalized, and there is adherence, I think we can then presume shale oil will be first to recover (or close to it), and I think you will continue to see a modicum of increased drilling that will not only replace the natural decline rate of existing wells, but will allow for increased production in the U.S.
By: Ty Chapman
Five Star Metals, Inc.
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