At OPEC's Vienna meeting, optics will be key

Myriam Robin

The member countries of the Organisation of Petroleum Exporting Countries will have a delicate balancing act when they meet in Vienna on Thursday to decide whether to extend an agreed cut in oil production that started in January to the end of the year or beyond.

There are near universal expectations that an extension will be negotiated. If it's shorter than the market is expecting, it could lead to a drop in the oil price, causing financial pain for some of OPEC's more cash-strapped nations. But if OPEC's public comments convince traders it will ensure oil stockpiles are reduced to their five-year average, it may embolden US producers to ramp up shale oil production.

The member countries of the Organisation of Petroleum Exporting Countries will have to execute a delicate balancing act when they meet in Vienna on Thursday. Photo: ERIC GAY

US shale oil production is due to technological improvements becoming cheaper, but is still more expensive than the production methods of used by OPEC members and so requires high prices to be profitable.

By June, it is forecast shale US shale oil producers, who have boosted production 10 per cent since September, will add 5.4 million barrels a day to the market. This is almost three times the 1.8 million barrels a day being removed through the OPEC production cuts, and could overwhelm the impact of OPEC's supply controls if prices continue to rise.

Optics are key, Citi's analysts told clients in a May 23 note, and will be more important than fundamentals in driving the oil price over the next month, which was on Wednesday trading at $US54.18, after trading below $US48 on May 5.

Earlier this week, Saudi Arabia's energy minister Khalid Al-Falih told Bloomberg that everyone he's spoken to believed a nine-month production cut was "a wise decision". "We think we have everybody on board", he said. Shortly afterwards, Iran's oil minister indicated his support for a nine-month cut.

Because of this, analysts at Citi expect a nine-month extension, and warn of an upset if it isn't achieved.

"The Saudis have moved expectations towards a nine-month market consensus and thus a six-month extension is likely to be punished," they wrote in a May 23 note.

Citi's analysts believe a six-month extension would be sufficient to tighten oil supplies significantly. But oil prices over the next month are likely to be driven by optics rather than market fundamentals, they wrote. "It would appear that a six-month extension would be a backtracking of sorts."

Citi, like most analysts, expects oil prices to keep their current levels, trading between $US50 to $US60 over the next year.

The big risk to the forecast is posed by US shale oil producers, who are not members of OPEC and may opportunistically add supply to the market if the oil price maintains these levels.

The question of how to keep prices high without encouraging more shale oil rigs to come into production is one that's been assessed by the analysts at Goldman Sachs, who believe the key to achieving this is for the oil market to go into 'backwardation' - a situation where spot prices are higher than futures prices.

Shale oil producers normally hedge their production, while OPEC members do not. As oil spot prices have been lower than futures prices since the end of 2014, shale oil producers have been able to sell their oil at higher prices than major OPEC producers.

Goldman believes futures prices below $US45 a barrel would be enough to halt the growth in shale oil production.

But achieving backwardation would require a coordinated three-part strategy, involving at first. deeper or more extended production cuts. This would then be followed by a commitment to raise production once inventors return to their five-year average (suggesting weaker short-term supply becoming more accommodative in the future) followed by a gradual increase in production, in line with demand to keep spot prices above futures prices.

"This seems quite a tall order," Goldman's analysts admit, "[b]ut it is important to note that this was how OPEC proceeded during the 1990s, with steady production growth, decent compliance with output quotas and a persistent backwardation outside recession."

The US government poses another risk to OPEC's attempts to erode oil stockpiles. US President Donald Trump has proposed selling more than half the country's emergency oil stockpile - which could flood the market with 270 million barrels of oil over the next decade to raise $16.6 billion.

Source: http://shink.in/uHKN5