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June 1, 2016

OPEC "Dazed and Confused"


By Robert Boslego, INO.com

OPEC will hold its 169th Meeting in Vienna on June 2nd. Its tentative program calls for a press conference to be held at 1600 hours. Don’t expect the fireworks that followed its conference 18 months ago when Saudi oil minister al-Naimi declared a market share battle against North American shale producers. In fact, don’t expect much of anything.


A lot has happened since the last OPEC meeting in December. A strong El Niño resulted in record high temperatures in North America during the first half of the winter, undercutting prices. Poorer members, such as Venezuela and Nigeria, implored the group’s richer Gulf state producers to cut back to stop the hemorrhaging. Saudi Arabia refused to budge.

The sanctions against Iran were lifted in early January. Iran proclaimed it would restore lost production of 500,000 to one million barrels per day. Crude prices tumbled further and by mid-January had dropped to the mid-$20s. The market panic was in full-force.

OPEC "Dazed and Confused"

At an industry conference in early February, OPEC Secretary-General Abdalla Salem El-Badri admitted that OPEC was not "expecting" the dramatic 40% plunge in oil prices that had materialized in the few weeks following its ill-fated decision in November 2014.

But El-Badri said-- in a rare admission--that the policy hasn't worked out as planned. "Shale oil in the United States, I don't know how we are going to live together," El-Badri said. Shale drillers can boost output in response to price increases much faster than anything OPEC has ever seen, he said.

Though Saudi Arabia has low production costs, it supports its country’s budget primarily by oil revenues. The Kingdom’s national budget breakeven was over $100 per barrel in 2015. As a result, it saw its financial reserves drain by over $10 billion per month.

In an apparent change of strategy, four producers - Saudi Arabia, Russia, Venezuela, and Qatar – soon met. News about the unexpected meeting caused prices to spike 12% on February 12th.

At the conclusion of their meeting, they announced a tentative plan to “freeze” production at January’s levels. Headlines began popping up from various sources, hinting at an agreement to freeze future output. The random nature of this “headline risk” altered the risk-reward prospects of speculative traders holding short positions. They began to liquidate (buy), pushing prices higher, which fed upon itself.

A meeting in Doha was set for April 19th in which almost all OPEC member plus Russia would meet. Headlines hinted that the freeze could be first the first step toward a cut. But Iran reiterated its stance that it would not, under any circumstances, agree to limit its production until it had restored its output to its pre-sanction levels.

In early April, Saudi Deputy Crown Prince Mohammed bin Salman (MbS), granted an interview to Bloomberg outlining a host of topics. He spoke of his strategy to diversify KSA’s income away from its dependence on oil revenues. At the heart of it is selling shares in Saudi Aramco, first through an IPO in 2017 or 2018, followed by additional sales, to create a Public Investment Fund (PIF) worth $2 trillion. Income from the PIF would be derived from non-oil investments, thereby reducing KSA’s risk exposure to oil prices.

During the interview, MbS made it clear that Saudi Arabia would not agree to a freeze unless every producer did. Given Iran’s position, the proposal seemed dead, but the meeting went ahead, under the belief that Iran would be granted its demand to restore its production before participating.

Iran’s oil minister did not even attend the gathering, though Saudi minister al-Naimi did, lending credibility to the idea that some accommodation would be made for Iranian production. But MbS had apparently instructed al-Naimi not to agree to any freeze, and so the meeting ended with no result.

A week later, MbS publicly unveiled his Vision 2030 plan for Saudi Arabia’s transformation away from an oil-dependent economy, and it was instantly adopted. In warp speed, the King announced a host of decrees, the most important of which put MbS second in line of succession. It also named a new oil minister, replacing long-time minister al-Naimi.

The “freeze” idea was dead. Prices had rebounded by almost 75% from mid-February based on this expectation. Prices might have collapsed then, were it not for a series of oil supply disruptions that began immediately. A confluence of unrelated circumstances in Africa, the Middle East and North America resulted in crude oil production outages. In Libya, a political crisis curtailed shipments. Oil thieves and saboteurs attacked Nigerian pipelines and wells. Workers went on strike in Kuwait and Canada's oil-sands region went up in flames. The combined total of oil production outages around the world was about 3.4 million barrels a day. Prices gained another 8%, small rise, given the size of the disruptions, signaling prices might have otherwise dropped precipitously with the freeze headline risks.

Over the past month, announcements by Saudi Arabia, the Gulf States, and Iran have made it clear that they are in a new race to expand oil production capacity. While disruptions may have brought the current world supply-demand balance into deficit, it now looks like there will be additions in 2017 that could keep the oil market from tightening once the current outages are restored.

In the crude futures market, the large contango term structure that had existed is gone, as nearby futures prices went up and long-dated prices came down. Crude futures prices could soon go into backwardation.

The Energy Information Administration is forecasting that crude inventories have peaked and will be drawing down over the summer, as domestic production falls quickly, and refinery demand for crude rises during the peak refining season. And some weather forecasters are looking for a particularly active hurricane season this summer, which could disrupt production in the Gulf of Mexico, just as Canadian production resumes.

The liquidations by managed money short sellers had amounted to purchases of 130 million barrels since February 9th, according to data from the Commodity Futures Trading Commission. If oil production is restored in the disrupted areas, oil short speculators could be a nearing a tipping point where they will jump back into the market.

Courtesy of Robert Boslego via INO.com

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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