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Opec ushers in the next market cycle

Opec and partners have cleared the glut—but will keep cutting. The strategy will support prices, but recreate the conditions that brought about the last bust

Forget "lower for longer", with Brent over $77 a barrel, the bottom of the oil-market cycle has passed and sentiment is now shifting. Perceptions of endless oil-supply abundance are fading. Glimmers of a less-fashionable ideathat production will be insufficient to meet future demandare reappearing. The next phase of the cycle is a price and investment upswing. The seeds of the next downturn are being planted.

The speculative money swamping oil futures tells the story. By late April, portfolio managers held 14 long positions for every short one, according to Reuters. No wonder. As it reaches supply-demand equilibrium, the market's tightness leaves it exposed to the kind of geopolitical event that, historically, has tended to confirm the end of an price trough. And the candidates for the shock are many: Venezuela's collapse; the Iran sanctions; rising Middle East tensions; or the potential for more deterioration in Libya.

Above all, despite the elimination of the surplus in OECD stocks to the five-year average—the stated goal of the cuts—Opec is not done cutting. Its linchpin Saudi Arabia, still planning to list Aramco and with an economic transition to fund, wants higher prices. Just ahead of the bi-monthly meeting in Jeddah of the committee monitoring the Opec and non-Opec cuts, a Reuters report said the kingdom was now eyeing $100/b.

Higher prices (in Opec language, "price stability") have always been the goal of the cuts; the OECD stock target was just a means to achieve them. The utility of that metric has now expired, so Opec has charged its secretariat to find a new one. It might be a longer-term stock measurement or a gauge of upstream investment levels. But the purpose is plain: to give Opec and its partners another signpost on the road to higher prices.


The metric might not matter, because cuts, of some volume, will continue for some time. It's not yet certain that June's Opec meeting will confirm a rollover of the quotas in place now. But undoubtedly much of the oil supply shed by the group and its non-Opec partners will not be returning to the market soon. Of the 2.4m barrels a day cut from production in March, almost 2m of it came from just five of the 22 producers in the agreement: Saudi Arabia (620,000), Venezuela (580,000), Mexico (310,000), Russia (250,000) and Angola (230,000). Of them, only Saudi Arabia and Russia could easily lift output.

This means that even if Kazakhstan continues to flaunt its quota this year, or Iraq comes good on plans to lift output by another 500,000 b/d, the losses will not be matched. That would require a change of policy from Saudi Arabia (and fellow Gulf producers). None is planned. Furthermore, one effect of Russia's underwhelming compliance with the cuts—Opec's data say it produced about 190,000 b/d more than it promised last year and 170,000 b/d more in Q1 2018—is that if it ends its participation, even as soon as June, the impact will be manageable.

Opec's cuts could get even deeper, even if that isn't agreed at the June meeting. Libya's output looks shakier than in months. The incapacity of Khalifa Hafter, head of the Libyan National Army that has secured the oil crescent since September 2016, puts its supply gains since then at risk, say insiders at state company National Oil Corporation. A 21 April attack on the Waha pipeline shut 70,000-100,000 b/d of supply and may be a sign of things to come.

Source: EIA, Baker Hughes, Reuters

Other supply-side risks will emerge before Opec meets in Vienna in June. US President Donald Trump has withdrawn from the nuclear deal with Iran and this will start to take effect. Sanctions experts disagree about the impact on oil exports (up to 1m b/d may be cut over 18 months, say the most bullish estimates), but agree some will be lost, and fret that it will be a precursor to war. On 12 May, Iraqi voters will elect a new parliament. No one can predict that outcome either but, at best, the horse-trading will paralyse Baghdad politics, including oil policy, for months. More menacing is the steady disintegration of Venezuela's oil sector. It has lost 500,000 b/d since the start of 2017 and was producing 1.49m b/d in March. Some analysts believe output could fall as low as 1m b/d, especially if presidential elections on 20 May trigger more sanctions from the US.

But underlying it all is Opec's—and Saudi Arabia's—belief that the market it ready to accept more oil-price inflation. The kingdom's energy minister, Khalid al-Falih, was clear after the meeting in Jeddah on 20 April that declining energy intensity, combined with higher productivity globally, meant the world had "capacity to absorb higher prices".

Global demand data and the broader macroeconomic picture support his view. The IMF's forecast that the world's economy will expand by 3.9% in 2018, its fastest rate since 2011, underlays the big agency forecasts. Opec reckons consumption will rise by more than 1.6m b/d this year. Others are even more bullish, saying the rise will be closer to 2m b/d in 2018.

The mood music is helping to change sentiment. The story of electric vehicles and transport efficiencies leading to a peak in oil demand has been replaced by tales of soaring SUV sales. American consumers, for example, will buy more gasoline this summer than they did the year before, when consumption set a record high, says the Energy Information Administration. A humming world economy means other big consumers will do the same. Opec expects Chinese demand to rise by 420,000 b/d this year. Indian oil consumption is rising by almost 8% a year, it says.

The bearish case 

Not everyone is convinced this bullish outlook can last. Nordine Aït-Laoussine, a former Algerian oil minister, warned Opec at a conference in Paris recently that it was about to undo its good work. "Having eliminated the stock overhang they helped to build up, the organisation appears determined to contribute to the revival of competing supplies," he said. Opec should keep in mind, he added, that its own forecasts showed that demand for its own oil would decline this year.

Surging US oil output is the main threat. Another rise in the American rig count—to 820, its highest level since the first quarter of 2015—came on the same day Opec had met in Jeddah. As long as Saudi Arabia keeps telling the market it wants prices to keep rising, American producers will keep drilling.

Yet Opec remains a relative sceptic about rivals' potential. Although it has increased its outlook for non-Opec supply in each of the past five months, its forecast of 1.71m b/d remains beneath the International Energy Agency's (1.8m b/d) and much lower than the EIA's (2.6m b/d). The discrepancy between the EIA and Opec forecasts is the difference between a balanced market and the build-up of another glut. Thus, according to Opec's data, if its output remains at Q1 2018's average of 32.1m b/d, stocks will be drawn down by about 500,000 b/d in 2018. But according the EIA, a surplus will emerge again to the tune of 160,000 b/d.

Worse still, for Opec, is the chance that successfully pinning the price above $70/b, let alone reaching the heady heights of triple-digit oil again, will re-ignite development in long-lead-time production like that in the deep-water sector and Canada's oil sands. Bitumen production costs have fallen steeply in the downturn. Even the most expensive new steam-assisted gravity-drainage projects could now break-even at between $55 and $70/b, according to consultancy Wood Mackenzie.

Source: Opec

Non-Opec producers are also getting some mojo back. This defies some of the talk from Opec ministers about how depressed upstream spending remains. Falih said he wanted to see "financial markets start financing and funding upstream projects". The UAE's oil minister, Suhail al-Mazroui, echoed this recently, saying Opec would know the market was balanced only "when we have enough investments". "We need to restore investments," said his Qatari counterpart, Mohammed Saleh al-Sada.

Yet Opec's own most recent market report noted a recent study from Wood Mackenzie, that, "the world's biggest energy companies are ready to undertake big projects once again"—with 30 new ones due this year ("more than the total that were approved in 2015 and 2016 combined"). The same report showed the global rig count to be 2,260 in March, higher than last year and well above the 1,673 of 2016. More rigs are likely. Martin Kelly, head of Wood Mac's corporate analysis, says that "capital investment, exploration investment and M&A spending will all increase by at least 10% year-on-year," in 2018.

Twitter vs Opec

Trump himself now seems a bearish wildcard. On 20 April, just as Opec's press conference in Jeddah got underway, he tweeted: "Looks like OPEC is at it again. With record amounts of Oil all over the place, including the fully loaded ships at sea, Oil prices are artificially Very High! No good and will not be accepted!"

He is out of date on the floating storage. But his intervention was still enough to shave some cents off the oil price, despite all the bullish news from Jeddah. The tweet might be read as an effort to deflect attention from rising gasoline prices in the US. Either way, he's brought American consumers' attention on Opec again, just as the driving season nears. US gasoline prices are rising-in mid-April, they were about $0.30 per gallon above their year-earlier level. At $2.74/g on average, they aren't at the wallet-busting heights of 2008. But mainstream media are starting to report the story. It's not a good omen for demand.

Even the global economic picture may now be as rosy as oil forecasters assume. Notwithstanding its forecasts for strong growth this year, the IMF is starting to worry, suggesting in its most recent global economic update that the GDP expansion would soon face some headwinds, including a bulging debt load and the end of loose monetary policy. Trump's threat to start a trade war—an unusually bearish geopolitical threat—are another factor. Several economists now say that the long period of economic growth in the American economy means it is now overdue a recession.

Source: EIA

But oil demand doesn't need an economic shock to start sagging. Opec's view that the world can take more price appreciation in its stride is not shared outside the group. "If we see sustained higher prices than current levels, there will be two effects," said the IEA's executive director, Fatih Birol, in New York recently. "One, US shale or Brazilian offshore will be much stronger than we have now. Second, robust oil demand growth may well be weaker than what we assume as a result of high prices."

This is why corporate oil producers around the world are both grateful for Opec's efforts to lift the price—and worried that they will go too far. "Strong demand growth was because of the low cost of oil," said Total's chief executive, Patrick Pouyanne, at the Paris Petrostrategies conference on 19 April. "When the price goes higher there will be a big impact on demand."

This is basic economics, but Opec seems keen to test the thesis, ready to ride the next phase in the cycle. Doubtful of non-Opec's longevity and impact as a source of supply growth, and sceptical that consumers will tone down their buying-ignoring, in other words, the experience of the past decade-Opec has moved from a strategy of balancing the market to underpinning the oil price. The industry should enjoy the bonanza while it lasts.


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