OPEC must talk bearish on the curve

It was nothing wrong with OPEC’s decision on November 30th to cut production in H1-17 by 1.16 mb/d versus October levels. What they did wrong and why their decision ended up being close to a shot in their own foot rather than a solution was their communication. When they decided to cut they gave a shine that they actually were back as a price setting organisation. Not just for the short term but also for the medium to longer term. The feel from the organisation at the end of November last year was the communication, stated or not, that OPEC don’t want an oil price below $50/b and that OPEC is aiming for an oil price of $60/b and lastly that OPEC was ready to use its size and muscles to support and achieve that. OPEC gave the shine that it was not just about a short term operation of draining the inventories. OPEC was actually there to support the level of $50/b and aim for $60/b. They probably had some remote hope and dream as well that they could actually deliver on this over the medium to longer term. I.e. that OPEC would again become the factor in the market setting the oil price within reasonable ranges. Deep down however they know that this is not in their power. In the longer term they have no control over prices. If the oil price heads to $30/b or $70/b (+/- $20/b versus today’s spot price) over the longer term it will have nothing to do with OPEC’s decisions but instead have all to do with technology, economic growth, investment cycles, resource availability etc. OPEC’s primary goal is to draw down current elevated inventories in order to remove the spot price discount versus longer dated contracts (whatever they might be). Last year that discount was $12/b and that cost OPEC a lost income of $150-200 bn as the organisation is mostly selling crude oil at spot prices.

It is in OPEC’s power to cut production and draw down inventories in the short term and thus remove the discount in crude oil spot prices. That is what they want. When the job is done the plan is to move back into full production again. That is however difficult if non-OPEC production has risen since when OPEC started to cut. That is the problem with the rising US crude oil production. It might be problematic for OPEC to move back into full production again once inventories have drawn down. So OPEC can cut as long as non-OPEC doesn’t revive when they do it. And that is where OPEC failed when they gave the shine that they were there also for the medium to longer term to support and set prices. “OPEC is back” was the perception. The result of OPEC’s actions, production cut decision and communication was that the medium term WTI forward crude oil prices rose from $52/b to $55-56/b and thus accelerated US shale oil recovery even more. And now we are here with US crude oil production at 9.1 mb/d and possibly reaching 9.5 mb/d in the end of May (if we extrapolate US production trend since the start of the year) when OPEC meets in Vienna on the 25th of that month.

OPEC can extend and cut production successfully in H2-17 but only if they get the communication right. They need to make it entirely clear that they have no plan to support or steer oil prices in any direction or to support the oil price at any specific level in the medium to longer term other than what the market actually stets it at. Everybody knows this anyhow it is just that markets so easily mislead themselves and gets side-lined from reality for periods. If OPEC wants to cut and draw down inventories they need to talk bearish on the curve in order to prevent it from rising while they cut since a rise in the curve would lead to an acceleration in US shale oil production and thus make it difficult for OPEC to move back into full operation again following the cuts. OPEC should make it clear that they plan to increase production according to their current market share along with global oil demand growth. OPEC has an overall market share of about 40%. If global demand grows with 1.3 mb/d then OPEC should make it clear that they plan to increase their production by 0.5 mb/d every year going forward. OPEC’s market dream is a tight spot oil market with high spot prices holding a substantial premium to longer dated prices. That would hand them a nice cash flow from spot crude oil sales while the much lower medium to longer dated oil prices constantly works to temper non-OPEC investments. A medium term forward WTI curve at $45/b would do the trick. So OPEC needs to talk bearish on the curve if they want to be successful with the cuts. If OPEC follows this strattegy it does of course mean downside risk for the medium to longer dated contracts. That will of course be no prediciton of where spot crude oil prices will deliver in the end. The forward curve is a tool in order to control investments in new oil production. More so than ever before with agile shale invenstments reacting directly on where the level of the forward prices are.

Kind regards

Bjarne Schieldrop
Chief analyst, Commodities
SEB Markets
Merchant Banking