Authored by Nick Cunningham via OilPrice.com,
OPEC has agreed to extend its production cuts for another nine months in an effort to bring the oil market back into balance. Keeping in place the 1.2 million barrels per day (mb/d) of OPEC cuts, plus the 558,000 bpd of non-OPEC reductions, for nine months rather than six should be enough to “normalize” crude oil inventories, according to most analysts.
Great. Mission Accomplished. By the end of the first quarter of 2018, the market will have tightened and OPEC members can go back to producing as they were before, producing as much as possible and fighting for market share.
But here’s the thing. When the deal expires and OPEC members open up the spigots again, it could create another glut just as before. That is the warning from a new Goldman Sachs report, which says that the oil market could find itself once again awash in oil in the second half of 2018 after the expiration of the OPEC deal.
“[W]e see risks for a renewed surplus later next year if OPEC and Russia’s production rises to their expanding capacity and shale grows at an unbridled rate,” Goldman analysts wrote in the research note.
While the extension of the OPEC cuts will succeed in bringing down inventories to normal levels over the next nine months, the problem is that oil production capacity continues to grow both within and outside of OPEC. Everyone knows the story of surging U.S. shale – drillers are coming back quickly, having achieved lower and lower breakeven costs over the past several years. Energy watchers are having to repeatedly revise up their forecasts for shale growth. The EIA says that shale production will grow by more than 800,000 bpd this year, with an annual average output of 9.3 mb/d in 2017 and a staggering 10.0 mb/d in 2018.
But it isn’t just U.S. shale that is going to grow between now and the end of the OPEC deal in March 2018. Canada and Brazil are both bringing new large projects online, and could together add more than 400,000 bpd this year. Russia is investing in new production capacity in the Arctic and the country’s output hit a record level just before the OPEC deal went into effect. Kazakhstan, a non-OPEC country that, like Russia, is party to the OPEC deal, has failed to comply with its commitments because it has oil fields in the Caspian that are ramping up.
Even within OPEC, there will be rising supplies. Iraq is targeting 5 million barrels per day of production capacity this year, sharply higher than its promised cap as part of the OPEC deal at 4.35 mb/d. Libya is aiming to add another 500,000 bpd or so to bring production up to 1.2 mb/d later this year. Saudi Arabia has also stepped up its rig count over the past year with an eye on long-term growth.
In short, despite $50 oil and upstream investment levels still a fraction of pre-2014 levels, supply is still growing. That means that when the OPEC deal expires, and everyone goes back to producing as before, the surplus will return. The OPEC cuts only work so long as they are in place.
However, all is not lost. Goldman Sachs suggests that OPEC has one tool at its disposal: bending the futures curve into backwardation, which is when near-term oil contracts trade at a premium to futures dated much further out into the future.
How can OPEC do this? Basically, if OPEC can signal that the market will tighten this year (by extending the cuts) while also simultaneously signaling that their output will increase once inventories normalize, they can provide a jolt to near-term oil prices while at the same time push down oil futures for 2018 and beyond.
Why would this matter? By lowering the prices of longer-dated oil futures relative to today’s prices, OPEC could try to derail shale growth, for several reasons. For shale drillers, it will make hedging more difficult, because companies will have to lock in next year’s production at lower prices if they really want to hedge. A downward sloping futures curve would also lower the stock prices of shale drillers since lower future prices will mean the companies are worth less. It will also jack up the cost of debt as lenders grow wary.
In short, flipping the market into backwardation would starve shale drillers of finance. “[T]he binding force to sustainably slow shale growth lies on the funding side and we believe that sustained backwardation can restrain access to the large pools of private equity and [high yield] credit capital,” Goldman wrote.
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Goldman's Damien Courvalin just updated his latest note, confirming latest supply-demand projections leave us expecting that such a 9 month extension will achieve a normalization in OECD inventories by early 2018, even with gradually declining compliance. The main challenge in our view will be the transition from cuts to market share and revenue growth.
Ultimately, backwardation will be required, in our view, to make these cuts a success and prevent an unbridled ramp up in shale production growth. Comments during the press conference acknowledged the potential need for further production management in 2018 with, however, no clear guidance on how production growth can be achieved.
The lack of (1) greater cuts, (2) potential caps on Libya/Nigeria, (3) a clear exit strategy beyond managing the 1Q18 seasonal build is driving prices lower, with Brent prices down $2/bbl so far. As we noted previously, we believe such a decline is not that surprising given (1) the shift in market focus from projected but uncertain future deficits to observable stock draws, (2) the poor Sharpe ratio of trading long-term fundamentals since last November’s OPEC meeting, (3) the disappointing pace of the draws and the fear that non-OECD draws, including among the producers supposed to reduce production, will further delay visible OECD stock draws, and (4) the concerns over the compliance of participants.
Given our forecast for inventory draws through 2Q and our expectations that OECD inventories can reach their 5-year average level by early-2018 through these cuts, our 2H17 Brent spot price forecast remains at $57/bbl.
We expect this will be reached by rising near-dated prices, as stocks draw, with long-dated prices likely declining further as the forward curve rotates towards backwardation.
Beyond the cuts, which will generate backwardation by normalizing inventories (the shape of the curve is driven by the level of inventories), we believe OPEC needs to create a credible threat that the oil market may return into surplus to finally slow the capital inflows into shale. This could be achieved by both expressing the goal of growing future production, and gradually ramping up production to grow market share but keep stocks stable and backwardation in place. In fact, the decline in long-dated prices today and a front driven rally in prices going forward would increase the odds of the cuts being successful as lower deferred prices can act to slow shale’s growth in our view. If backwardation is not achieved, however, we see risks that prices fall sharply next year as OPEC reverts to growing market share through volumes.