Monitoring the Oil Market After OPEC Agreement

Monitoring the Oil Market After OPEC Agreement

The days before OPEC’s meeting in Vienna, comments suggesting difficulty reaching an agreement sent prices down nearly $3 a barrel; the announcement of an agreement immediately sent prices up nearly $3 a barrel, and as now they remain above $50, some are warning of a climb-down.  People who aren’t familiar with commodity markets must surely think that traders have the attention span of goldfish. But the reality is that while daily price moves do indeed tend to overreact to news but frankly are not that important except to some traders.  Naturally, news will change prices because those trading on the instant react to current events (and rumored events) rather than continuing to rely on monthly oil market forecasts.

Now that an agreement has been reached between OPEC producers and some non-OPEC countries (Azerbaijan, Kazakhstan, Mexico, Oman and Russia), and Saudi Arabia has stated that it will cut production slightly below the earlier pledged level, the market will certainly firm further, at least this week.  After that, expect careful monitoring of compliance and reaction to either glimmer of evidence of either strict observance or leakage.  It doesn’t help that two nations, Azerbaijan and Mexico, are essentially donating supply cuts according to anticipated natural decline in production, which means that there won’t be any actual news to report, as there will be when tanker traffic at Ras Tanura drops off.  Also, reporting from Russia should be all but completely discounted given that Russia is the Saudi Arabia of fake news.  Instead, look for customers to state whether their volumes are being cut or not. 

Of course, individual reports of oil deliveries being reduced are of limited value, since there is always the potential for oil to simply be diverted to other customers (especially ones that can be expected to keep their mouths shut) or sold on the spot market.  Some producers (hint-Iran) might maintain production but put some of the output into storage.  It won’t be for several months before there is reasonably reliable data as to the level of compliance, but here are some ways to judge beforehand.

First, the big producers matter far more than the small ones.  Oman’s pledge to reduce production by 40 tb/d is pretty much noise in the system.  Whether or not they cut will be hard to tell, because that much oil amounts to one supertanker load a month, and it is hard to know when an extra tanker at the end of the month represents overproduction or just a delayed delivery from the earlier month.  Watch Iraq and Saudi Arabia in particular, but also whether or not Iran manages to ramp up beyond what is permitted; it would have difficulty doing so, but if it did, or shipped oil now in storage.

Next, watch the contango in the market.  It has been increasing of late (figure below) suggesting that storage is growing, or at least the gap between actual and desired storage is growing.  

This is probably the earliest indicator of the actual market balance, but can be influenced by misinformed expectations. For example, buyers think the production cuts are experiencing heavy compliance and so their desired storage increases. 

Tanker rates can be a useful indicator, although they are not as clearly transparent.  If VLCC rates go up, it implies that either someone is planning to store oil (such as an OPEC member that agreed to cut production, but instead is cutting exports), or that shipments are not dropping (or both).  If they decline, it is a bullish sign for prices, meaning less oil is being shipped, especially from the Arabian/Persian Gulf.  Same thing holds for tankers on the Baltic market:  the Russians are unlikely to reduce crude shipped by pipeline, so Black Sea tanker rates should hold up.

By late December, there should be reports from customers about volumes being offered (or not), and this should clearly show cuts from Kuwait, Saudi Arabia and the U.A.E.  However, the contributions of Iraq and Russia are less certain, and traders will be parsing whatever information they can get for evidence of either compliance or cheating.

Mid-January will see early estimates of production levels will appear from private sources (consultants, trade press, etc.) but these will be highly uncertain. Comments from OPEC ministers, especially al-Falih of Saudi Arabia, about their perception of compliance and price levels.  Hints and rumors will move prices more than hard data at this point.

Production estimates should be more firm by late January and a price trend will firm up.  If compliance appears spotty, prices will drift down towards $45, whereas if Iraq and Russia in particular show firm adherence, prices could threaten to breach $60.  At the same time, drilling in the U.S. Southwest shale basins might be rising sharply which would give pause to the Saudis, suggesting that they might need to encourage prices to drop.

By February, whether or not Trump’s election victory is threatening to trigger an economic slowdown should becoming clear, and provide some clarity as to demand levels.  Also, at this point if prices have firmed well above $50, it’s likely that leakage will occur, especially the non-Gulf producers but also whether Iranian production has been able to rise above agreed-upon levels, Venezuela has used the increased revenue to restore some shut-in supply, and if Russia shows signs of backsliding.

Ultimately, the price will depend on the Saudi view of whether or not markets are balancing and, if they are not, if the reasons reflect temporary effects such as recession or more fundamental problems like rising U.S. shale oil production.  If the only concern is non-compliance to quotas, expect another round of weak prices followed by new negotiations and stronger threats from the Saudis to other producers to comply or suffer from low prices. 

Recall 1998, when repeated warnings from Saudi Arabia to the other producers, nearly all of whom were over quota, but especially Venezuela, were not heeded and the Saudis were forced to retaliate, bringing prices down to $12.  That level might not be seen again, but $30 remains a possibility if a new price war breaks out.