Comment: A little less conversation, a little more action please
Ehsan Khoman, head of Research in MENA at MUFG, discusses what the latest decision from OPEC to extend the cut in oil production means for the market
Elvis Presley certainly knew how to get a reaction from his audience.
Last year OPEC invoked similar levels of frenzy by announcing a plan to cut production for the first time in eight years. Oil prices soared. Last week, at their meeting on the 25th of May, OPEC announced a nine-month extension to this deal.
The extension, long expected by the market, resulted in a sharp drop in the price of oil immediately following the rollover announcement.
Somewhat ironically, the clear guidance and well-telegraphed statements of endorsement from Saudi and Russian energy ministers for a nine-month extension, led to disappointment from the market, which had largely already priced in this rollover.
Hopes across the market were for an increase in the volume of cuts by each party member, with expectations high that a deeper round of cuts than the 1.8mn barrels a day announced last year would be forthcoming.
The lack of a ‘surprise’ regarding the size of cuts led to the drop in oil price, although this went on to recover.
The decision to support an extension points to notable developments for market participants.
Firstly, the rollover agreement is a strong signal to the market that OPEC intends to continue supporting prices at the expense of market share. This is a major U-turn; this time last year OPEC was committed to shoring up market share in an attempt to choke off American shale production.
However, the shadow of shale still looms large, with producers proving far more resilient than most expected. They are now leaner, more efficient and smarter, as operators continue to improve drilling and completion techniques, leading to lower operational costs.
OPEC has responded with a change in strategy, that is now concentrated on driving up the price of oil.
This illustrates just how much OPEC is prepared to take an interventionist role. It’s commitment to production cuts has been unwavering to date; 1.2mn barrels have been cut per day compared to just 100,000 from non-OPEC members.
Comments from Khalid Al-Falih, Saudi Arabia’s energy minister, that “we will do whatever it takes” to improve demand – which are so similar in tone to Mario Draghi’s 2012 pledge to save the euro – further highlight the strength of commitment from Saudi policy makers.
An important factor underpinning this change in strategy is the forthcoming Saudi Aramco float, signalled for 2018. With a potential value of $2tn, Saudi Aramco will be the biggest public offering ever made.
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The higher the oil price when Saudi Aramco floats, the higher its valuation is likely to be. A significant incentive for Saudi Arabia to balance the supply/demand equation, to ramp up prices.
This leads questions to another important consideration; the details of the post-deal exit strategy. Last week, Khalid Al-Falih stated that the nine-month rollover could be extended if necessary. He refused to be drawn further however, saying “we will cross that bridge when we get there.”
Markets have been pushing ministers in recent weeks to reveal more detail on what a post-deal exit strategy would look like, fearing a return to a battle for market share between OPEC and shale producers.
Given the refusal to provide more detail on the post-exit strategy (perhaps because there isn’t one at the current juncture), markets are going to continue to push for clearer guidance once this second deal lapses in March 2018.
However, keeping markets in the dark about an exit allows OPEC to keep the door open for another extension. This might become an attractive option if the Saudi Aramco float is delayed past the first half of 2018 and oil prices have not yet recovered sufficiently.
So far, the agreement to cut oil production, which has been in place since the start of this year, has only helped to stabilise the price of oil. Brent crude oil is roughly in line with its average of around $50/barrel over the past year.
But we remain optimistic that the price of oil will rise modestly over the rest of 2017, averaging $56/barrel for Brent and $D52/barrel for WTI. The market continues towards rebalancing and this extension of cuts will tighten fundamentals.
As a result, we can expect a material, sustained drawdown in inventory supporting oil prices this year going into 2018, we expect Brent prices to rise further to average $60/barrel whilst WTI prices to average $55/barrel.
“A little more bite and a little less bark,” goes the Elvis Presley song. Had OPEC surprised the market last week with an increase in the depth of cuts, prices would have shot up.
It goes to show how sometimes giving the market the guidance it craves means you don’t get the reaction you’re driving for. OPEC should bear the king in mind when it next meets in November.