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Many moving parts to the output deal -
Cheating may not be fully apparent until 2Q17 -
Saudi January exports may demonstrate first commitment
The oil market’s euphoria over OPEC’s momentous decision Wednesday to cut production was on pause a day later, as traders digested the agreement, which represents a major gamble for kingpin and deal driver Saudi Arabia that supply and demand were indeed on the path to rebalancing.
The agreement, which calls for OPEC to cut some 1.2 million b/d from October output levels for six months, contains numerous ifs, conditions, and risks, with no guarantees Saudi Arabia will gain the revenue boost it seeks without sacrificing the market share it has so fiercely defended.
OPEC members have a notorious history of cheating on their allocations, and previous attempts to coordinate policy with other countries, notably Russia, have also been plagued by noncompliance, a salient point as the organization seeks cuts of 600,000 b/d from major non-OPEC producers.
«Where prices ultimately end up at the end of 2017 hinges on many moving pieces outside of the proposed cuts,» said Tony Starkey, managing director of analysis for Platts Analytics’ Bentek Energy.
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«In a worst case scenario, the likes of Saudi Arabia may not get as much price uplift as intended should demand underperform, US shale outperform, Libya and Nigeria outperform, or any combination thereof,» he added.
Libya and Nigeria have been granted exemptions from the deal due to their production having been hit by militancy. Both countries could add a combined 600,000 b/d or more in the coming months if internal problems ease.
Still, most analysts were largely in agreement that the output deal — if fully implemented — would induce stock draws in 2017 and hasten the market’s rebalancing, as OPEC desires.
Even if some producers cheat on their assigned quotas, the deal includes some cushion in output levels that could still obtain an effective result.
The combined OPEC and non-OPEC cuts total 1.8 million b/d, roughly what OPEC’s own analysts project the oversupply to be for the first half of 2017.
But Starkey noted the International Energy Agency and the US Energy Information Administration have projected surpluses of about half that, meaning that as long as about 900,000 b/d of cuts are sustained, inventories will be tapped.
That had many market watchers bullish on the deal, despite concerns over how it will be enforced.
«Even with the inevitable lingering questions about interpretation of commitments and verification of compliance, we expect the net result to accelerate balancing of the market in 2017,» analysts with FBR & Co. said. «Most importantly to our view, the deal will stem the cycle of competitive OPEC capacity additions, allowing demand growth to catch up to supply.»
PROOF OF COMMITMENT
Despite some public warnings on Tuesday, the eve of OPEC’s meeting in Vienna, that Saudi Arabia was prepared to walk away from the negotiating table, by all accounts the kingdom was eager to get a deal done to bolster prices — as long as other countries were willing to share in the cut burden. Saudi Arabia, which has been producing at or near historic highs over the past few months, will get a chance to demonstrate its commitment to the deal, with state-owned Saudi Aramco due in the next few days to announce its nominated export volumes for January.
Declarations of firm commitments to cut or at least freeze output from non-OPEC producers at a December 9 meeting in Doha that OPEC has scheduled could further drive confidence in the deal and support oil prices.
OPEC’s monthly oil market reports, which contain secondary source production estimates for each member, will help verify compliance, at least from within the organization.
Cheating on the quotas will not become readily apparent until well into the second quarter of 2017. But by then, producing nations likely will have enjoyed several months of elevated prices before the market fully factors in any overproduction.
Counterintuitively, sustained supported prices may lead to more stringent compliance with the quotas, as producer countries will not want to risk a steep selloff as the market catches on to any cheating.
Conversely, sustained low prices could encourage cheating as producers seek to make up for lost revenues through higher volumes.
«For investors with a higher risk appetite, we find outright long positions attractive, targeting a move to $60/b or above,» Giovanni Staunovo, an analyst with UBS, said in a note.
CONSISTENT SAUDI STANCE
The agreement marks a return to supply management for OPEC, after two years of a pump-at-will policy to defend market share instead of price.
Saudi Arabia was the main architect of that policy, with then-oil minister Ali al-Naimi prevailing on the producer group at its November 2014 meeting to eschew an output cut in the face of oversupply brought on largely by US shale.
As the price slump persisted, to the dismay of virtually every producer, Naimi was prepared to agree to an OPEC-led output freeze at a meeting in Doha this April. But Iran’s refusal to participate in the freeze prompted Saudi Arabia to withdraw from the deal, and negotiations collapsed in acrimony.
Since then, Naimi has been replaced by Khalid al-Falih, who has maintained as Naimi did that Saudi Arabia would be willing to participate in a coordinated cut only if all major state producers were willing to contribute.
Falih told reporters in Vienna his stance remained consistent, even as many OPEC watchers saw his willingness to cut a deal with concessions for geopolitical rival Iran as a significant shift in Saudi Arabia’s approach to the market.
«The principles haven’t changed,» Falih said. «We’ve repeated over the last few months that…any production constraint agreement has to be distributed in a fair way and a transparent way.» What has changed since Doha is that Iran has significantly ramped up its production to near pre-sanctions levels, where it has mostly plateaued, while Iraq has also boosted output and largely maxed out its export levels. Saudi Arabia was not willing to rein in its own production while either country was in position to take its market share.
The deal reached in Vienna, then, largely gives each of the three major players within OPEC a favorable outcome that is palatable politically, while also boosting revenues, even as Saudi Arabia bears the bulk of OPEC’s cuts.
EVIDENCE OF REBALANCING
The deal still has many skeptics, and for good reason, as OPEC has no mechanism to enforce compliance or punish cheating. The agreement is based on nothing more than trust, as the market will have to place its faith in Saudi Arabia’s assessment of supply and demand balances and the willingness of producers to cooperate.
For at least one day Wednesday, major oil producers were the beneficiaries of a run-up in prices, as traders reacted enthusiastically to the signal that Saudi Arabia was ready to put a floor under the market.
To hold the mood and ensure market rebalancing happens on its terms, Saudi Arabia will have to put its money where its mouth is, lead by example through output discipline and hope enough producers follow suit.
Analysts with Barclays also noted the deal was an agreement to cap output and not exports, so it may not have an immediate and substantial effect on market balances.
«OPEC continues to be successful at keeping the market guessing and will continue to do so until it sees evidence that stocks are drawing more actively in the first half of the year,» the bank said, maintaining its first quarter price forecast of $57/b.
«Should countries exercise full compliance with the intended cut, we see upside risk to our estimate.»
–Staff reports, newsdesk@spglobal.com
–Edited by Jeremy Lovell, jeremy.lovell@spglobal.com
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