OPEC members and some non-OPEC producers including Russia are most likely going to decide to maintain current production cuts for another six to nine months. Inventories are likely to draw down towards normal at the end of 2017. It will be supportive for oil prices in H2-17 and would likely lift the front month Brent crude oil contract to $60/b by the end of 2017. The risk is however that US shale oil production is stimulated to grow yet more driving both 2018 and 2019 into strict surplus. It may thus be increasingly difficult to exit the cuts further down the road. It thus poses a downside price risk to 2018 unless some cuts are kept all through 2018 as well as 2019.

“We think that we have everybody on board” said Saudi Arabia’s energy minister Khalid al-Falih (Bloomberg) following a meeting in Vienna on Friday in preparation for the ministerial OPEC meeting on May 25th this week. Both OPEC and some non-OPEC producers were present. He stated that everybody he had talked to viewed a nine months extension of the cuts in H1-17 as a wise decision. Apparently there thus seems to be a unanimous support for an extension of the current cuts. There still seems to be some discussion whether to extend the cuts to Dec 2017 or to Mar 2018.

On November 30th last year individual OPEC members decided to cut production by 1.17 mb/d versus their October production level while a group of non-OPEC producers joined in with a promised cut of 0.6 mb/d. Thus a pledged cut from both OPEC and non-OPEC members of close to 1.8 mb/d. Both OPEC and Russia have delivered on their pledges with OPEC’s production down 1.14 mb/d averaging 32.1 mb/d so far this year while Russia’s production was down 0.3 mb/d in April versus November.

Oil demand will jump seasonally by close to 2% (close to 2 mb/d) from H1-17 to H2-17. Thus production cuts will get a tailwind help by this seasonal jump in demand. If OPEC keeps its production at 32 mb/d in H2-17 we expect global oil inventories to draw down some 350 mb. OECD’s commercial crude and product inventories are today some 300 mb above normal. Some of the draw down may however take place in unspecified non-OECD inventories.

When OPEC decided to cut production last November it did talk about prices. An oil price of $60/b was mentioned many times. That was probably a mistake as it helped to shift forward crude curves higher and helped to stimulate US shale oil rig activation unnecessary.

Now there is no talk about an oil price level. The whole focus is on inventories. When oil inventories are above normal and rising then the crude curves are in deep contango which means a large spot price discount to longer dated crude contracts. Last year the front month Brent crude oil contract had an average discount of $12/b versus the five year contract. Since OPEC mostly sells its oil in the spot market it lost some $150 – 200bn last year solely due to this spot price discount of $12/b. When oil inventories are below normal and the market is tight then the forward curve is instead backwardated with spot prices at a premium to longer dated prices. That is what OPEC desires and long for.

OPEC knows that it cannot control the oil price over time. Especially it cannot place it at an artificially high level over time without having to accept a continuous decline in market share which over time is of course unsustainable. OPEC can however intervene in the market in the short term. The goal now is to draw down oil inventories. To move away from a contango market with a spot price discount which has been the situation since mid-2014 and instead hoping for a backwardated market with a spot price premium over longer dated crude prices. “Give me a premium!” is basically what OPEC is asking.

Over the last year we have learned that when the WTI 18 months forward crude oil contract is below $47.5/b then the number of US shale oil rigs is declining. When it is above it is increasing. This rig count inflection point is of course not cut in stone. It rises with cost inflation and declines with volume productivity growth. Over the last year the oil price has stimulated US shale oil to expand continuously. The number of oil rigs is still rising, but productivity growth has lately halted to zero on the margin while cost inflation has accelerated. The inflection point may thus start to rise if US shale oil production is stimulated to expand yet more in response to a positive price signal following further production cuts.

Three examples of price settings and dynamics in a global oil market with US shale oil on the margin:

1)US shale oil at neutral with normal inventories:

WTI crude 18 month contract = $47.5/b (no expansion or contraction in US oil rig count)
Brent crude 18 month contract = $50.0/b (Brent crude trades at a $2.5/b premium to WTI)
Brent crude 1 month contract = $50.0/b (Brent crude oil curve is flat)

2)US shale oil accelerating in a deficit market with below normal OECD inventories:

WTI crude 18 month contract = $55.0/b (Solid expansion in US oil rig count)
Brent crude 18 month contract = $57.5/b (Brent crude trades at a $2.5/b premium to WTI)
Brent crude 1 month contract = $65.0/b (Brent 1 mth at a $7.5/b premium to the 18 mth)

3)US shale oil is slowing in a surplus oil market with above normal OECD inventories:

WTI crude 18 month contract = $40.0/b (Solid contraction in US oil rig count)
Brent crude 18 month contract = $42.5/b (Brent crude trades at a $2.5/b premium to WTI)
Brent crude 1 month contract = $35.0/b (Brent 1 mth at a $7.5/b discount to the 18 mth)

Thus even if we assume that the US shale oil rig count inflection point is fixed at $47.5/b in the above three different exemplified states it still leaves the Brent crude oil front month contract to range within a large span of ranging from $35/b to $65/b. Then add cost inflation/deflation on top of the expansionary and contractionary phases and the span becomes even larger.

If production cuts are maintained for another six to nine months we expect it to drive OECD inventories down to normal or below by year end 2017. It is also likely to hold oil prices at such a level that it stimulates US shale oil rig activation yet further. The market will thus move towards a state depicted in example two above: A market in deficit due to production cuts with inventories below normal and a crude oil curve in backwardation. That is of course as long as the market is still in deficit.

The big question is what will happen when the cuts end in six to nine months. Rosneft’s CEO, Igor Sechin, has asked the Russian government to draw up a plan for an orderly exit from the ongoing production cuts. He sees a clear risk for a renewed competitive battle and price war if US production growth is not contained and production cuts ends uncontrolled.

It is clear that the likely decision to cut for another six to nine months will stimulate US crude oil production to grow yet more. Our projection is that US crude oil production will grow by 0.52 mb/d y/y in 2017 and by 1.51 mb/d y/y in 2018. However, if the oil price stimulates the US shale oil rig count to grow by 30 rigs/month (its current pace of expansion) from July 2017 to March 2018 then we project that US crude production will grow 2.3 mb/d y/y in 2018 driving the market into strict surplus for both 2018 and 2019 (assuming sufficient labor, materials and services capacities in the US shale oil space).

The risk is thus that if cuts are extended (as now seems likely), then there is likely going to be a need for cuts all through 2018 and 2019. Else the market is likely to shift into surplus, growing inventories, a crude curve which shifts from backwardation to contango again and a price level which needs to move down again in order to send a signal to US shale oil producers to reduce the number of oil rigs in operation again. I.e. the oil market could possibly shift back to phase 3) above again for a while.

If production cuts are extended and OECD inventories are drawn down towards normal by year end we expect the Brent crude oil curve to flip into backwardation by some $5/b versus the 18 month contract. It also seems reasonable to expect the the US rig count inflection point to shift up $5/b from $47.5/b to $52.5/b. Since Brent crude trades at a $2.5/b premium to WTI it places the Brent 18 mth contract at $55/b by year end. Adding a backwardation premium of $5/b to this means that the front month Brent crude oil contract would trade at $60/b by the end of 2017. The head-scratching problem is then that 2018 and 2019 may have shifted into surplus if 30 rigs are added per month from Jul-17 to Mar-18.

Kind regards

Bjarne Schieldrop
Chief analyst, Commodities
SEB Markets
Merchant Banking