After all of the horses had been traded, OPEC finally came through – announcing a cut of around 1-1.2m barrels a day. In assessing the quality of the news we have to consider three primary factors – size, risk of non-compliance and the clarity of the announcement.
With regards to size, the production target of 32.5mbbld (million barrels per day) matches the more bullish number that OPEC mentioned in their September meeting and represents a cut of c.1mbbld from the most recent OPEC production numbers, as released by the IEA (International Energy Agency).
If adhered to, this sort of cut will tighten markets and could bring the OECD crude inventory glut back to a normalised level by the middle of 2018. The act of the oil markets tightening and inventories falling will create a tailwind for oil prices, sending it back towards the cost of supplying the most expensive barrel to the market (marginal cost) of c.US$70.
The second factor to consider is will OPEC comply or cheat? Despite a much maligned reputation, OPEC have an 85% compliance rate during their previous periods of cutting (2008-9, 2000-2 and 1998-9).
Saudi is, unsurprisingly, the leader of the pack and are likely to fully comply together with their Gulf Cooperation Council (GCC) partners UAE, Kuwait and Qatar who represent a further 300kbbld of the cut.
Indeed, Saudi and OPEC would lose all credibility, if they were to renege on a deal that they themselves insisted on. OPEC spare capacity is also so low at the moment that cheating on the quotas would present a significant challenge.
OPEC countries have been producing as much as they could anyway which is one of the reasons why we were confident that they would follow through with a cut. As such, we anticipate that the compliance for this deal will be higher than the previous periods.
Surprisingly, it was also announced that non-OPEC will also cut by 600kbbld, something that will be further discussed in a meeting on 9 December in Doha.
Russia will be responsible for half of that cut (300kbbld). This effectively brings forward the normalisation of inventories to the end of 2017, which would be very bullish for oil prices. There is probably a lower chance that Russia will fully comply with the cut. However, if they are close to production exhaustion as we suspect, then the cut is more likely.
The meeting was positive for oil prices and OPEC in almost all regards. Saudi have certainly played their part in helping to restore the credibility of OPEC. In allowing Iran to actually increase production to their pre-sanction levels, whilst Saudi shoulder the largest share of the cut in OPEC’s history, they can be regarded as the ‘rain makers’.
In allowing this ‘concession’, it also illustrates how determined they were to get a deal through. The pain that the economic downturn is inflicting on the populace is creating a period of potential regime instability that the rulers are compelled to navigate.
The third factor that we were looking for was whether the announcement was clear and transparent. Looking at the detail, we can conclude that this clarity was provided and there appeared to be a distinct lack of ‘fudge’. A table outlining all of the various production targets was even created.
OPEC will meet again on 25 May 2017 when they expect to extend the cuts by another six months, taking us to the period when inventories could be normalised. The next question is whether or not OPEC have used all their ammunition. Historically they have averaged 4mbbld cuts with a low at 3mbbld.
Where does this leave investments? Share prices in the energy sector should see ongoing strength, buoyed by an oil price that will likely continue to narrow the discount to marginal cost. This narrowing of the gap is necessary in order to bring back much needed long term offshore project spending that still delivers 30% of oil supply.
In the meantime, cheaper onshore US tight oil which fulfils approximately 5% of global supply, should see significant activity and earnings growth as they grab market share.
However, this production will take a number of months to find its way into the market and will likely enter the market at a time when inventories are a lot lower and at a volume which is unlikely to upset the tightening dynamic.
We should also remember that thanks to two and a half years of price pain, 2018 will see a real dearth in large/mid-scale project completions and consequently a significant dip in net new oil from offshore oil hitting the market which leaves considerable room for US light tight oil (shale oil) to grab market share over the coming years.
Richard Robinson is manager of the Ashburton Global Energy fund