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Opec's Venezuelan supply problem

It's hard to see how the Opec-non-Opec agreement would survive a steep decline in Venezuelan oil output in 2018

The biggest point of contention during the Opec meeting on 30 November, say people who were in the room, was the plan to impose a cap on Libya's and Nigeria's oil output. The outcome wasn't clear. Opec's communiqué said nothing, leaving Saudi oil minister Khalid al-Falih to announce that they had agreed not to exceed their 2017 highs in 2018. It meant, he said, that there would be "no surprises" for the market.

In terms of something for bulls to latch onto, that was about it from the Opec meeting. Otherwise, the key takeaway of the deal was that it would be subject to review during the year-at the next group-wide meeting in June, for sure, but also at compliance-monitoring meetings before then. That was a Russian condition and it will linger in the market's mind throughout 2018.

But one country didn't get much attention during the Opec meeting. It's the one that, if Libya and Nigeria are now contained, could truly surprise the market in 2018and not in a good way.

That country is Venezuela. And it's not too hard to paint a picture for 2018 in which its demise conspires to do two things: first, bring a strong rally in oil prices; and, second, in doing so kill off the Opec-non-Opec deal itself.

The market has become accustomed to the slow-motion car crash of Venezuela's oil sector. Once, even under Hugo Chávez, state company PdV's plans to increase output to 5m barrels a day looked doable. Then came the strikes, the sackings, the asset-grabs, the mismanagement, and the political dysfunction. From output of 3.3m b/d a decade ago, the fall has been steady. In November this year, production was down to 1.8m b/d, according to Platts. Venezuela couldn't even produce enough to meet its Opec quota of 1.97m.

But outright collapse could come nextand that isn't something the market is used to. Balances from banks and other forecasters presume the decline will continue roughly as it has. Morgan Stanley, for example, expects Venezuela to shed just 100,000 b/d of supply between end-2017 and end-2018. Energy Aspects thinks 200,000 b/d could be lost. Barclays is the most aggressive, forecasting a drop of 300,000 b/d.

It could be much worse. The oil-export data of recent months have been ominous. Norway's DNB reckons Venezuela shipped just 1.18m b/d in October and 1.2m in November, or more than 300,000 b/d less than in July. The drop probably reflects the diversion of heavy crude to domestic refineries, to make up for lost output from dying conventional fields. Still, it's oil the international market is not receiving.

And if recent decline rates aren't lowered, Venezuela's output could drop by 0.5m-0.6m b/d by end-2018, further cutting exports. This seems increasingly plausible, because PdV is in a death spiral. Exports to the US"Venezuela's most important cash-paying market"are now just over a third of their level earlier this year, leaving ever less money to spend on halting the decline. Recent arrests of PdV executives and the appointment of a military man, Major General Manuel Quevedo of the National Guard, to run both the oil ministry and state oil company, don't speak of a government with a plan to turn things around.

The debt crisis-sovereign and for PdV-gathers momentum. Having already technically defaulted on some payments, Venezuela must pay another $2.4bn due in the first half of next year. But treasury reserves are just $10bn, so Caracas doesn't have cash to spare. As inflation runs out of control, it is already forced to choose whether to spend money on food imports for people or diluent to mix with its heavy oil to make it exportable. Increasingly, China seems unlikely to ride in with a bail-out.

How will this affect Opec?

Recent price strength was already a reason Russia and some Opec members were reluctant to extend the deal. And Venezuela's crisis is undeniably bullishespecially if the supply losses next year turn out to be greater than forecasters expect.

Even if Venezuela's supply declines as gently as some expect, Opec will have a problem. Either its cuts will effectively increase from 1.8m b/d to 2m b/d or so (the agreement plus the further losses from Venezuela), or some members will start to produce more to plug the Venezuelan gap. This dilemma deepens the more output Venezuela loses.

If Opec did nothing to match the losses, the oil price would rally hard. In turn, the cutters already concerned by price appreciation could ditch their commitment. In the alternative scenario, where other Opec producers replace the losses, who would pump more to compensate for Venezuela? It seems hard to imagine that Iraq, for example, would stand by while Saudi Arabia filled a gap in the heavy oil market. A new group-wide deal would be necessary, at least.

In short, it's easy to see how Venezuela's accelerating production losses could lift oil prices into the $70s next year. But it's hard to see a fragile Opec deal surviving such a rally. Venezuela, not Libya, is the surprise that could undo the Opec extension in 2018.

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