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Opec primes the pump

The latest target rollover means more crude is on the way.

Brent at $65/barrel is 40% beneath its price last year; rig counts in the US have fallen by more than half in the same period; the industry has wiped $100 billion off planned capital investment; and even Saudi Aramco, the world’s biggest crude exporter, is cutting travel perks for executives. The crude supply glut is taking its toll.

Yet within Opec everyone agrees the world needs more oil. That, combined with the remarkable resilience of unconventional oil producers in North America, means the glut is likely to continue for some time.

The group’s decision in Vienna on 5 June to keep its 30 million barrels/day (b/d) output target in place was unanimous. Ali Naimi, the Saudi oil minister, even described the meeting as “amicable.” 

The decision will make little difference in the short term. Opec has consistently produced beyond its target for the past year -- in May, output was 31.33 million b/d, its highest level since August 2012 -- and the group’s 30 million b/d target has lacked the detailed member quotas that would give it relevance anyway. 

Opec production and spare capacity

In the medium term, the price volatility associated with Opec’s half-yearly meetings should diminish. The group isn’t going to cut output while it maintains a laissez-faire approach to prices; and its de facto leader, Saudi Arabia, isn’t for turning. Opec has always maintained it isn’t in the business of setting prices -- and for now, that’s true. 

This is a new situation for the market. The Saudis hadn’t expected the sharp fall in prices that followed last November’s meeting. Indeed, as Petroleum Economist revealed at the time, had Russia and Mexico agreed to curb their own production the kingdom may have endorsed Opec-wide cuts too. 

But since then the tactical ploy to force higher-cost producers out of the market or whip others into line has hardened into a full-blown strategy to lure back buyers in the US and China. Saudi exports have risen sharply this year and a source close to the minister says the bar for cuts is now impossibly high: Norway and even Kazakhstan would have to join in too. “Zero,” is how Naimi responded when an advisor asked him what the chances of such broad non-Opec cooperation might be.

More oil

Consequently all its members now want to raise production -- even if only some of them can. Total Opec output may rise sharply again in the coming months. Libyan production is now at a third of capacity: as much as another 1 million b/d would be available in the unlikely event that security were restored. 

Venezuela and Kuwait both plan to increase output significantly in the next few years. 

Iraq’s oil minister Adil Abdulmahdi said on 5 June that his country’s capacity would soon reach “much more” than 4 million b/d and by 2020, another leap to 6 million b/d is plausible, he said. (Officially the ministry still forecasts 9 million b/d by then.)

Then there is Iran, keen to increase output by 1 million b/d within six months of a nuclear deal. That agreement may wait until the autumn, according to people in Vienna familiar with the talks. Iran won’t increase production as quickly as it hopes but up to 30 million barrels of Iranian oil now in storage could be released almost immediately. 

Naimi said in Vienna that it was the “sovereign right” of any country to produce as much oil as it wants. But that does not mean the willing surrender of customers they won from Iran thanks to sanctions, so if Iran is to rejoin the market, it will have to discount. So will Iraq. A new supply line of Basra heavy from the country’s south -- 800,000 b/d have been available to Asian – mostly Indian – buyers since the start of June -- is already being discounted by $3-4/b against Basra light.

All of this points to much more oil, priced cheaply, hitting the market over the next 12-18 months. “2016 could be very ugly,” a senior Opec source said. Intra-Opec competition, and how it plays out, will be a supply-side theme for the year.

US crude oil and liquid fuels production

Waiting for proof

Cheaper oil should drive down margins and curb costly production while persuading consumers to buy more. But it might not be that simple. Demand would have to far outpace supply to bring down historically high inventories before prices could sustain a recovery. Or non-Opec output would have to fall to make room for new output from Opec itself.

On both counts the smoking gun is still elusive. In the first quarter, global supply was 3 million b/d above the year before. Demand is growing faster than it did in 2014 and will rise by 1.4 million b/d this year, says the International Energy Agency (IEA). But demand data lag supply data by months, so the picture is not clear and previous forecasts have been wrong. A decade in the making, secular consumer shifts in consumption will probably take more than a year of low oil prices to reverse. Pointing to expectations of global economic growth of 3.3% this year and 3.6% next, Opec thinks oil demand will still only rise by 1.18 million b/d in 2015. But another bout of macro-economic risks makes these model uncertain. The OECD has already slashed its forecast for economic growth this year from 3.7% to 3.1%. Citi, a bank, forecasts just 2.7% for 2015.

China is one conundrum. Strip out the Chinese stock-filling programme, estimated by analysts at Bernstein to have soaked up almost 400,000 b/d of supply in the first quarter of 2015, and Q1’s global demand surge, put by the IEA at 1.7 million b/d year-on-year, looks less rosy. Slower expansion of its economy, which the Chinese Central Bank expects to grow by 7% this year, could further curb its thirst for oil. On 8 June, official data from Beijing showing a 17.6% fall in imports and 2.5% fall in exports, would have worried Opec’s exporters, used to relying on China’s consumers. As Chinese stock farms near capacity, oil imports have plummeted. In May, they were under 5.5 million b/d, and 1.9 million b/d beneath the number for April. The end of a period of refinery maintenance should tell the market whether that was a blip or a trend.

Beyond China things are mixed. The IMF expects the Indian economy to grow by 7.5% this year and next, potentially yielding the kind of oil-demand surge that analysts have repeatedly forecast. 

In Vienna, some executives attending the Opec Seminar, an industry conference that took place before the group’s meeting, were bullish about OECD oil demand too. But rich-world demand will rise by a miserly 0.8% this year, believes the IEA – better than the stagnation of recent years, but hardly thrilling.

US demand may still shock on the upside, dragging the OECD data higher. One senior executive at Toyota pointed to a sharp rise in sales of trucks in the US, where this year’s driving season will, some believe, show a much greater recovery in the world’s biggest oil consumer. But only later will the oil market know if rising US demand was enough to draw down record-high stocks, lift imports, or compensate for slower demand growth in China.

As for supply, low oil prices are pushing some “inefficient” (Naimi’s word) producers out of the market and slowing the rise in non-Opec output - but with oil as high as $60-65/b, the declines will be modest and probably short-lived.

In the US, rigs are still yielding more oil, as drillers – many of which used the market’s recent rally to hedge new production – are focusing on their most profitable wells. That allowed US output to hit another high in early June of 9.6 million b/d. The EIA predicts total liquids production will start falling gently from that peak through the rest of the year (see graphic), before starting to climb again in the second half of 2016 as more Gulf of Mexico fields come on line. Overall, the EIA still expects US crude oil output to post annual gains. In Canada’s oil sands companies are slashing budgets, which will temper longer-term output projections, but production from developments already underway means more oil, at least for the next 18 months.

Spare capacity?

Some American producers appear to welcome the fall, as it forces efficiencies on the system. In early June, ConocoPhillips’ chief executive Ryan Lance told an audience -- including Opec ministers -- that tight oil production costs had already fallen by 15-30%, and would drop by another 20% before 2020. The market was doing its job of price discovery, he said, and unconventional oil “would survive at $50 or $60 Brent pricing”. Other majors were adamant that lower oil prices might affect the timing of some developments but not their enthusiasm to keep producing more oil. 

What could strengthen prices? Supply-side risks still trouble some market watchers. Although Opec’s secretary-general Abdalla El-Badri says the risk premium in the market has disappeared, it could always return.

Other analysts fret that as Saudi output rises, Opec’s spare capacity falls, meaning any supply disruption would be harder to fix. In May 2013, the group had 3.23 million b/d to call on. Two years later, the reserve has fallen to 2.38 million b/d (all but 270,000 b/d of it in Saudi Arabia). That’s about the level it was during the great bull run of 2008, when the shrinking spare capacity helped push the market to its all-time high.

But that was before the onslaught of non-Opec supply, which has left global stocks – first responder to any crisis -- brimming with oil. Beyond the inventories, the market still has plenty of spare capacity to draw on, especially at $65/b – but a lot of it is found in Texas and North Dakota, as well as Saudi Arabia. US unconventional supply has changed the way the market will think about spare capacity, says Jamie Webster, global oil-market analyst at IHS, a consultancy. So price-sensitive is the tight oil sector that any spike following a supply disruption would prompt a rise in drilling and output a month or two later.

The fast reaction of tight oil producers to price changes will probably be seen later this year. If production in the US begins to fall as the EIA expects, prices should start to rise, bringing more oil back on stream. 

With swing production coming from outside Opec, it’s difficult, says Ed Morse, head of commodities research at Citi, “to understand how the oil market will be able to sustain higher prices or even a return to last year’s prices given the entry of shale oil, deep-water output and oil sands into the production system”.

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