The cartel basically faces three choices. First, OPEC could cut production beyond the 1.2mn b/d agreed in December and encourage non-OPEC members to deepen the cuts. Second, OPEC could increase output aggressively and restart the oil price war. And third, OPEC could keep the cuts at the current levels for the next six to nine months and hope for oil market demand conditions to improve. So what will OPEC do? In our view, the cartel will extend the cuts and pretend everything is fine.
If OPEC cuts production further, it will lose market share. During the painful oil price war of the last couple of years, OPEC and Russia collectively increased production by almost four million b/d since mid-2014, sending WTI crude oil prices spiralling down to $26/bbl. The rapid expansion in output enabled OPEC to gain market share over other producers like the US and China. However, this surge in market share came at an enormous cost, and the agreed cuts have led to a reversal in OPEC+Russia market share in recent months.
If OPEC hikes output, oil prices could collapse to $35/bbl. The exact opposite alternative to cutting supply is of course to increase it and get back to a price war. Yet this option is almost unaffordable for the cartel at this point, in our view, given both current account and government budget breakeven positions. Historically, every 1 million b/d change in global oil balances has typically resulted in an average oil price change of $15/bbl. So bringing back supply and reigniting a market share war could send Brent into the $35 to $40/bbl range, or possibly even lower. These price levels would likely choke US shale production, but would also strain OPEC.
In our view, neither Saudi nor most of other OPEC members can afford this scenario right now. With most cartel members already experiencing large government deficits across the board at current oil prices, a $10 to $15/bbl drop would be devastating to OPEC. Crucially, FX reserve positions of core members like Saudi Arabia have been deteriorating pretty quickly for the last three years. A renewed oil price war would likely exacerbate the FX reserve drain by triggering a rapid deterioration in the capital account, a very risky economic outcome.
As a result, we believe OPEC will stay the course. Staying the course with ongoing cuts and hoping for a global oil demand improvement remains the most likely course of action as OPEC meets. Stronger demand into 2018 and 2019 would surely help clear the global glut. So maintaining the current discipline of production cuts is key and we expect the current quotas to hold for the most part. After all, compliance levels with the agreed cuts across the cartel have remained at around 96 per cent in the past four months, highlighting OPEC’s commitment to clear the surplus. Iraq is perhaps the one country that may try to renegotiate next week, but its compliance track record is more mixed anyway.
One of the biggest challenges facing the cartel is that global oil demand has expanded at a rate of just 1.0 million b/d in 1Q17 down from a breakneck pace of 2.1 million b/d in 4Q16. But forward-looking indicators such as the ISM and PMI surveys around the world suggest a pick-up in global economic activity. Our economists see global GDP growth firming over the next few quarters from 3.1 per cent in 2016 to 3.4 per cent in 2017 to 3.8 per cent in 2018, lending support to global oil demand. Thus, we continue to expect world oil consumption to expand by 1.3 million b/d this year and 1.2 million b/d next year, an encouraging sign for OPEC.
Source: CPI Financial