For months in Energy & Income Advisor, we’ve argued that OPEC would struggle to finalize a credible deal to reduce output and prop up oil prices.
After major oil-producing countries announced a tentative accord in late September, we pointed out the deal’s obvious flaws and suggested that the whole process likely amounts to an effort to jawbone oil prices higher during a period of seasonal weakness.
We’ve also rejected irresponsible headlines in the mainstream media about Saudi Arabia’s purported U-turn on production cuts and crude-oil prices.
Although the prospect of an accord among OPEC members prompted many market participants to become bullish on oil prices, our formerly out-of-consensus views remain valid—and the market appears to be coming around. WTI has sold off significantly since peaking at more than $50 per barrel in mid-October.
Handicapping OPEC policy is admittedly much tougher than when its members met in early December 2015. At that time, an agreement to cap or cut production appeared unlikely without a meaningful decline in US oil output.
Today, OPEC can at least claim that its policies have helped to dent non-OPEC production and the industry’s capital spending on exploration and development. That said, US shale production would ramp up if oil prices remain above $50 per barrel for an extended period.
With this caveat in mind, here’s our basic assessment of OPEC policy.
We put the odds that OPEC’s Nov. 30 meeting will yield an agreement with country-level production quotas at 50-50. The probability of such a deal increases the farther oil prices prices tumble. Conversely, if oil prices were to recover to about $50 per barrel, the organization could argue that the market is rebalancing itself.
However, even if the next OPEC meeting yields a credible deal, the probability that this agreement involves a meaningful reduction in supply ranges between 25 and 30 percent. The likelihood that this accord targets production cuts of about 1 million barrels per day or more is no better than 10 to 15 percent.
What does this range of outcomes mean for oil prices?
If OPEC announces a meaningless agreement akin to the one after its meeting in Algeria or punts the decision to 2017, oil prices could tumble into the $30s per barrel this winter. Weakness in equities as part of a global risk-off trade could also contribute to this downside.
A deal that involves modest production cuts, flexible output targets or an OPEC-wide quota likewise wouldn’t prevent further downside in oil prices, especially if member states cheat—a distinct possibility, based on historical precedents.
The only credible production agreement would involve the members of the Gulf Cooperation Council (GCC) reducing their output. Saudi Arabia would need to promise to cut its oil production by a greater magnitude than the normal seasonal decline that occurs after the summer cooling season. If the GCC members agreed to sustained reductions of at least 1 million barrels per day, WTI would quickly surge to between $55 and $60 per barrel.
Such a deal faces significant obstacles.
Iran, Iraq, Nigeria and Libya all hope to grow their oil production beyond their current levels, with Iraq disputing OPEC’s estimate of its total output.
Bloomberg estimates total OPEC production at more than 34 million barrels of oil per day in October—up from 33.58 million in August—reflecting recovering output in Libya and Nigeria.
The tentative agreement in Algeria calls for OPEC to trim output to between 32.5 million and 33 million barrels per day, implying a reduction of 1 million to 1.5 million barrels per day from production levels in October. The necessary cuts will increase in magnitude as Iran, Iraq, Nigeria and Libya continue to ramp up their output.
Recent trends in US oil production and drilling activity may also worry policymakers in Saudi Arabia.
Weekly data from the Energy Information Administration suggest that US output has stabilized at about 8.5 million barrels per day, while the US oil-directed rig count has increased by 40 percent from its low at the end of May. Producers continue to add rigs in the Permian Basin and Oklahoma’s Anadarko Basin, areas that offer compelling economics with WTI in the $40s per barrel.
Given these developments and Saudi Arabia’s focus on retaining market share, policymakers probably don’t want oil prices to climb to more than $55 per barrel for a sustained period.
Saudi Arabia also recently completed the largest bond sale ever by an emerging-market nation, raising $17.5 billion and attracting $67 billion worth of bids for these issues.
That talk of a potential production deal and consequent rally in oil prices coincided with Saudi Arabia shopping this massive bond issue to prospective investors in London, Los Angeles, Boston and New York City hardly comes as a surprise.
Bottom Line: Our base case remains that the upcoming OPEC meeting yields an underwhelming agreement on production and that seasonally weak demand combines with elevated inventories to pull oil prices back into the $30s per barrel over the next one to three months.
This sort of move creates both dangerous conditions for many energy companies, as well as and unique opportunities for investors. Our in-depth coverage in Energy & Income Advisor examines both the short-term trades to take advantage of the move and companies that can thrive during the long haul. Consider downloading a free issue to see for yourself.
Elliott H. Gue is founder and chief editor of Capitalist Times and Energy & Income Advisor.