Discussions of extending OPEC cuts through March 2018 have buoyed oil prices and moved June 2017 WTI futures up by over $4.00/bbl to $50.57/bbl. However, despite price support this summer in anticipation of extended cuts, the market remains concerned about the global supply and demand outlook post an OPEC rebound, with $1.00/bbl of backwardation in the curve from March 2018 to July 2019. This begs the question, is extending cuts to provide price support the optimal choice for prices long-term or do the Saudis have any other choice as they prepare for Saudi Aramco’s IPO in early 2018?
Successful implementation of 1.7 MMb/d of OPEC cuts have finally begun to work off the crude global supply glut. That’s good news for prices. However, that supply shortage is not expected to draw down inventories fast enough to bring levels in-line with normal historical levels before the first round of OPEC cuts are slated to end in just over a month. Thus, as Saudi Arabia looks forward to its announced IPO of Saudi Aramco in early 2018, it is in a difficult position. Do they extend cuts to support higher prices that are more desirable for the IPO and put the curve in backwardation to drain inventories but risk continued growth from the US? Or do they let production cuts roll off in July and let prices collapse in the hopes that US producers are hit hard and respond with declines in production?
Letting the cuts roll off in July could send prices careening towards $30/bbl as the market plunges back into oversupply, but will it trigger a fast-enough US supply response in time for Aramco’s 2018 IPO? When prices collapsed in late 2014 there was a 24-month lag between prices and aggregate global production declines. While there is not nearly as much momentum or cash in the system to prop up the E&P industry to the same extent this time, activity in the Permian Basin has ramped dramatically in the last 12-18 months. This momentum, paired with active and significant hedging activity is likely to delay the production impact from falling prices.
The chart below shows incremental demand available for the US, Russia, and OPEC to capture as global demand grows and production in other areas declines. For example, in 2Q 2017 with OPEC cuts in effect, the US and Canada are the only two areas growing to support new demand and the gap between incremental supply and demand shows that storage is going to be required to back-fill OPEC cuts. However, in 3Q 2017, if OPEC production rebounds as originally planned, then there is more incremental supply coming to market than demand and any excess crude above incremental demand would have to go into storage and increase global inventories. However, if OPEC continues cuts into 2Q 2018 then there will be a continued shortage of supply growth to meet demand growth leading to storage declines until OPEC rebounds in early 2018.
This creates a unique challenge for OPEC and could leave Saudi holding the bag and forced to maintain cuts in hopes that storage inventories will decrease and provide support for higher prices in 2018. While this is not a guaranteed, or even a likely outcome, an OPEC production rebound in July will most certainly push prices lower ahead of Aramco’s IPO.
Given recent announcements, it seems Saudi has decided that ending cuts now is unpalatable. Instead, it appears that the Saudis will continue to support an extension of production cuts in the hopes of price support.
Both options hold significant risk, but, at the moment, the bet appears to be on OPEC cut extensions as the lesser of two evils.
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