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Market Outlook

Why OPEC’s Math Doesn’t Add Up

By Elliott H. Gue, on Dec. 5, 2016

Oil price fluctuations continue, along with meetings and talk from OPEC about production cuts. Given how important oil’s price is to the broader market, this article breaks down where OPEC’s math falls apart, and where we see oil in the next few week.

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Despite the significant upswing in the oil prices, WTI has merely retested its June and October 2016 highs.

OPEC’s accord also isn’t as surprising as some commentators have suggested. Oil ministers talked down the prospects of a deal in the run-up to the meeting, perhaps as a bargaining ploy or to provide a cushion if OPEC members failed to reach an agreement.

When OPEC members jawboned prices lower, WTI sold off; when the organization announced a deal to cut production, oil prices snapped back to levels last seen a little over a month ago.

As the meeting approached, we put the odds of a deal at 50 percent and the likelihood of a meaningful agreement to reduce production at about 20 to 30 percent.

The agreement calls for a production cut of 1.2 million barrels per day, plus another 600,000 barrels per day from non-OPEC members. Russia is expected to account for a third to half of the non-OPEC cut, though policymakers have since asserted that it could take time for the country to comply.

Saudi Arabia took the lead on cuts, agreeing to reduce its oil output from the reference level of 10.544 million barrels per day to 10.058 million barrels per day, starting in January. This cut of 486,000 barrels per day was lighter than we expected.

The kingdom lifted 10.67 million barrels of crude oil per day in August and has already reduced its output by 80,000 barrels per day from this peak. Saudi Arabia usually reduces its output by 300,000 to 400,000 barrels per day between the end of summer and January, because demand for air conditioning declines in the fall and winter.

Based on these historical norms, Saudi Arabia’s oil output would decline to as low as 10.28 million barrels per day by January 2017. Accordingly, Saudi Arabia’s effective production cut amounts to about 200,000 barrels per day—less impressive than the headlines would suggest.

The agreement also expires in six months, when the kingdom usually ramps up its output to meet domestic demand for air conditioning,

And if we add up all the proposed production levels for January and keep Indonesia, Nigeria and Libya constant, the total comes to 32.68 million barrels per day—not the 32.5 million barrels per day that OPEC has claimed. Recoveries in Libyan and Nigerian production could also push OPEC’s output well north of 33 million barrels per day.

The International Energy Agency’s most recent estimate of the call on OPEC—or the volume of crude oil that the organization must pump to balance demand and third-party supply—at about 33 million barrels per day for the first half of 2017.

Assuming OPEC members comply with their agreed-upon production cuts, the market might rebalance in the first half of 2017. That said, we’re not convinced that these reductions will be enough to draw down bloated global inventories in the first two quarters of next year.

We also doubt whether Russia’s oil output will decline by 200,000 to 300,000 barrels per day, leaving much of the reduction in non-OPEC production to come from Mexico, China, Colombia and other countries where insufficient investment has led to weak volumes. Investors shouldn’t misconstrue these natural declines as voluntary output reductions.

Meanwhile, US oil production continues to ramp up, increasing by about 275,000 barrels per day from its low this summer. And the upsurge in the oil-directed rig count suggests that US output could exceed 900,000 barrels per day or more by next summer—an increase of about 300,000 barrels per day. If weekly production estimates from the Energy Information Administration (EIA) confirm this trend, the glut (and investor sentiment) could worsen.

Most OPEC members also have a checkered history of complying with production cuts. Although Saudi Arabia, Kuwait and the United Arab Emirates will probably live up to their end of the bargain (a reduction of 756,000 barrels per day), we doubt that Gabon will reduce its output by 9,000 barrels per day or Angola will curtail production by 80,000 barrels per day.

And because the agreement won’t take effect until Jan. 1, 2017, the market won’t be able to gauge compliance until February and March.

OPEC’s ability to influence prices has diminished relative to past cycles.

If WTI rallies too far above $50 per barrel, short-cycle shale production in the US can come onstream relatively quickly. What will OPEC do the next time oil prices tumble to $40 per barrel? We doubt a meaningful production cut would be in order.

Front-month WTI prices could climb to about $52 per barrel in the short term, but we expect traders to fade this rally over the remainder of 2016 if inventories remain elevated. The odds that oil prices will fall to less than $40 per barrel are higher than a rally to more than $55 per barrel.

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