One year after OPEC pulled off what many considered impossible, and on November 30, 2016 in Vienna the cartel managed to reduce oil production by most OPEC and several key non-OPEC nations by 1.2 million barrels daily in an effort to reduce the global oil glut, this time things are looking far more shaky, at least according to Goldman Sachs which in a Monday afternoon note writes that the outcome of OPEC’s November 30 meeting is far more uncertain than usual for two main reasons: i) Russia has yet to endorse Saudi Arabia’s proposal for a 9-month extension to production cuts and ii) fundamentals pointing to an accelerating rebalance of the oil market.
In "OPEC's Quagmire", a worried Damien Courvalin writes that unlike last November's OPEC meeting, this time there is no firm consensus over the Saudi-proposed 9 month extension with Russia refusing to sign off. The Goldman energy analyst is concerned that "the absence of such a consensus is due both to the uncertainty on the progress of the oil market rebalancing as well as Brent oil prices trading at $63/bbl."
What is really troubling Courvalin, however, and the reason why Goldman is especially worried that oil may slide after this year's OPEC summit, is that "with the rhetoric not matching the logic for the first time in years, the outcome of this meeting is much more uncertain than usual." As a result, Goldman view risks to oil prices "as skewed to the downside this week" as current prices timespreads and positioning "already reflect a high probability of a nine month extension." In other words, the most likely outcome with oil trading as high as $59 as recently as last week, a price which is sure to unleash shale production, is disappointment.
OPEC meeting aside, Goldman continues to model a base case for oil output which includes a gradual ramp up in OPEC & Russia production from April onward. As a result, Courvalin writes, "the announcement of an only six month extension would still initially appear bullish relative to our expectation, creating upside risks to our $58/bbl 1H18 Brent forecast." However, once the price rises higher - as it already has - Goldman expects "compliance to deteriorate and prices to sequentially decline as OPEC and Russia come to the realization that the New Oil Order is alive and well and that prices have overshot the industry’s marginal cost."
In short, Goldman is buying all the oil that it is advising its clients to sell at current prices.
Goldman's full thoughts are below:
Uncertain outcome to OPEC meeting but downside price risk
- Support for a nine month extension to the cuts by Saudi and others is likely driven by a perception of still elevated excess inventories. The OPEC Secretariat estimates September OECD inventories 154 mb above their five-year average, only half-way normalized from a peak of 380 mb. As has historically been the case, OPEC’s assessment of oil fundamentals has a bearish bias which may incentivize such a long cut, with the IEA estimating the excess at only 119 mb. Consequently, the Secretariat’s global demand, non-OPEC and OPEC NGL production forecasts require an extension of the OPEC’s 3Q17 crude production of 32.7 mb/d through end-2018 to bring OECD inventories to their 5-year average levels.
- Russia appears less convinced on the need for such a long extension and the accompanying higher oil prices that Middle East OPEC producers likely welcome. Russia's TASS news agency reported on Tuesday November 21 that oil producers and the Energy Ministry had discussed a six-month extension. Yet on Thursday 23, the Economy Minister said economic growth had been hurt by the deal because it dampened investment - the first such negative comment on the cuts by a senior official. This uncertainty was also visible in Russia’s Energy Minister comments on Friday 24: while he stated that “the targets on rebalancing the market have not been reached, everyone supports the extension", he also commented that “the oil price has reached its balance" and that he expected the oil price to remain between $50 and $60 a barrel this and next year with "different options under consideration".
- Comments by Russia over the past year that the cuts should remain data dependent to assess their effectiveness further suggests it will likely seek to avoid committing to a nine month extension until closer to the cuts' expiration. More broadly, we see a increasing disconnect between the rhetoric of a nine month extension, four months before the cuts end and in the face an accelerating rebalancing and the logic of a short-duration cut to normalize inventories followed by higher output to increase revenues and market share. Given this set-up, we believe that the outcome of this week’s meeting remains more uncertain than in past years.
- Despite this uncertain outcome, we view risks to oil prices as skewed to the downside this week as we believe that current prices, timespreads and positioning reflect a high probability of a nine month extension with only limited remaining upside heading into the meeting. First, the survey conducted by our European energy equity team during their annual Natural Resources conference in London on November 15-16, suggests high expectations for a nine month extension. Second, we recently estimated that the recent rally in Brent oil prices likely reflects a $2.5/bbl “nine month extension” premium, which suggest such a possible down move if the meeting fails to deliver it. Third, commodity markets are not anticipatory assets and, as we learned this year, pricing in expectations of strong compliance of a debatable cut a year away would likely prove self-defeating.
- From a positioning perspective, the record net long speculative length across the oil complex also suggests downside price risks into this OPEC meeting, as was the case in June 2015 and May 2016. While the recent increase in short-dated put skew suggests some rising concerns over the meeting's outcome, we find that near-dated ATM implied volatility levels do not yet reflect a high risk premium for Thursday. Specifically, we estimate that short-term ATM implied Brent volatility implies a $2.5/bbl daily move on Thursday, which is no greater than our assessment of the Brent forward curve's current "nine-month extension premium". Despite the historical pattern of Brent implied volatility typically declining after an OPEC meeting, this suggests that ATM oil implied volatility offers decent value into the event (even if put skew is rich).
- To be clear, we do not expect a month-long collapse in oil prices like the one that occurred after the May 2017 meeting either, as the lack of a nine month extension would be in response to strong fundamentals. Despite the lack of an agreement so far, there are no indications that the meeting could end without some form of extension, with, in our view, a strong incentive to formalize collaboration for 2018 and beyond with the group returning to broadly following quotas like it did in the 1990s, when it doubled production. Alternative agreements could be for a three month extension which would take the agreement through the next regularly scheduled semi-annual OPEC meeting and/or an extension with a framework for tapering the cuts tied to the state of the market rebalancing.
- The announcement of a nine or even six month extension would be at face value bullish relative to our forecast of a gradual ramp up in OPEC & Russia production next year from April onward. Specifically, we expect production to increase by 600 kb/d in 2Q-4Q18 vs. 1Q18, on the view that OPEC will aim to maintain inventories normalized (on a days of demand coverage basis) and given our non-OPEC ex. Russia supply and global demand forecasts. While a six or nine month extension would therefore leave risks to our $58/bbl 2018 Brent price forecast skewed to the upside initially, our fundamental projections and conceptual oil framework would still lead us to expect that compliance would deteriorate and that OPEC and Russia would grow production and prices subsequently decline. There are three drivers to this view:
- We are more optimistic on oil demand growth given the ongoing solid global growth momentum and the still relatively low oil prices. Our above consensus demand growth forecasts of 1.7 and 1.6 mb/d in 2017 and 2018 are cumulatively 0.2 mb/d higher than OPEC’s projections and 0.4 mb/d above the IEA’s. Even if OPEC targeted 5-year average inventory levels, this would require a shorter cut.
- We believe that OECD inventory levels underestimate the state of the oil market rebalancing. First, the growth in North America production comes from far inland deposits that require new infrastructure and have offset production declines from either offshore or nearly costal fields (VZ, Mexico, Colombia, Neutral Zone, Nigeria, Yemen). In the US alone, we estimate that 40 mb of crude inventory now sits in new infrastructure (pipeline and tank bottoms) and can no longer be considered “excess”. We further believe that oil inventories should be adjusted for demand levels to correct for a steadily growing oil market. On that basis, we believe that the oil market is further along to having rebalanced than OECD inventory levels suggest.
- Of course, this is a moot point if OPEC sticks to targeting inventory levels. The reason we believe our metric will likely prove binding is that normalizing inventories would have a bullish price impact and lead to a supply response elsewhere. Specifically, Brent timespreads have exhibited a historically stable relationship to inventory in days of demand coverage (less so in levels) which implies that at 5-year average inventory levels, Brent oil prices would be $64/bbl, $6/bbl above prices on normalized inventories in days of demand coverage. At such price levels, we expect a supply response from US and other non-OPEC producers (including Russia) that would reduce OPEC market share and revenues over time.
We therefore believe that OPEC will eventually address this nuance and the risk of over tightening inventories.
- The just finished 3Q17 earnings provided further evidence that the New Oil Order has yet to run its course. Majors reported further cost deflation offshore, with evidence of rising drilling activity as well. And while US E&Ps appear more fiscally conservative, ongoing capital efficiencies and slower than expected cost inflation appear mostly offsetting. As a result, the recent rally would negatively impact 2H18 and 2019 oil fundamentals if sustained, leading to a decline in prices below our $58/bbl forecast over time. Already, the US horizontal oil rig count is up 19 over the past three weeks, likely in response to the rally in WTI prices above $50/bbl in September given the typical 2/3-month time lag, with current $59/bbl prices likely leading to further increases in activity if sustained.
- In conclusion, we believe that oil prices have overshot fundamentals and that price risks are skewed to the downside into Thursday’s meeting. With prices $6/bbl above our forecasts, however, we see risks that even a mildly disappointing outcome could initially keep prices above our $58/bbl Brent forecast. Yet, if the threat of geopolitical tensions fails to materialize in new disruptions, we believe that prices will trade lower in coming months: first the estimated $3/bbl current geopolitical risk premium will not be sustainable and second, we believe that prices have already overshot the industry’s marginal cost of production. In fact, the longer prices remain at current levels in the absence of new disruptions, the greater the downside risks to our 2019 $58/bbl Brent forecast: first from higher non-OPEC supply and second from the realization by OPEC that their cuts or rhetoric have overshot, leading to a potentially more aggressive ramp up in production to not lose market share and revenues.
- OPEC meeting timeline: On Wednesday, November 29, the five-country Joint Ministerial Monitoring Committee - composed of Russia, Venezuela, Algeria, Oman and chaired by Kuwait - will meet at the OPEC Secretariat, where it will assess compliance with the deal, review market conditions, and possibly draft recommendations on the future of the cut agreement. The OPEC+ meeting will take place on Thursday November 30, with a closed session of OPEC ministers and the secretary general starting at noon local time (11 GMT and 6 am ET), according to the agenda posted on OPEC's website. If the meeting lasts for three hours as currently planned, it would be followed by the combined meeting of OPEC and non-OPEC ministers and delegates at 3 pm local time (1400 GMT, 9 am ET). After that, there will be a news conference. OPEC has invited 20 additional countries beyond the current 24-country coalition to the meeting, including Norway, Brazil, Colombia, Ghana, D.R. Congo, Egypt, Indonesia, Chad, Cameroon, Republic of the Congo, Niger, Mauritania, Cote d’Ivoire, Turkmenistan and Uzbekistan (Norway, Brazil and Colombia have declined the invitation).