In a development that went against the market’s hopes and expectations, oil prices plunged shortly after the long-awaited agreement on extending production was announced by OPEC members on Thursday in Vienna.
As the cartel and some non-OPEC producers extended their pledge to cut 1.8 million barrels per day of output until the end of the first quarter of 2018, crude futures were down 5% to near US$50 a barrel. US WTI Crude price fell, dropping from US$51.46 on Wednesday to US$48.90 on Thursday, before paring some of the losses.
The volatility continued into Friday, with Brent prices hovering around – but not much higher than – the US$52 mark. The drop was particularly painful coming off a one-month high of US$54.67 just hours before the deal was announced, highlighting the market’s disappointment.
“I think the main thing is that we saw exactly what the market was prepared for – and therein lies the issue. The market had effectively priced in the news of the 9 months extension,” said Christian Lawrence, Senior Strategist at Rabobank.
According to the expert, while the market had expected nothing less than what was delivered, it had fragile hopes that OPEC could offer more by way of cuts – either in terms of length or volume.
“The results we are seeing are a perfect unwind of that expectation,” he admitted.
Much of this frustration stems from the fact, barring the additional three months, the cartel offered little to no advancement to the current 6-month agreement. The quotas remained the same, with a large chunk of the cuts once again carried by the KSA; Iran agreed to freeze at 3.8mn bpd, while Libya and Nigeria will still be exempt from the deal.
Perhaps the only real development was the welcoming into OPEC of Equatorial Guinea, which immediately accepted a symbolic cut of 10,000bpd, while Egypt and Turkmenistan declined to participate.
But the outcome of the summit failed to answer some of the more pressing questions and concerns about the oil market. One issue it failed to address is the discrepancy between the promised and announced curbs in production, and the actual impact on the global glut.
Some market observers noted that the impact on supply has been weak – and delayed – due to the loopholes inherent in the current agreement.
“We have seen this many times before,” blogged Vadim Zhartun, analyst at Nova Team consulting agency. “First, the exporters involved hike up production to their limits, filling up their inventories to the tip. Then they introduce the cuts from this record-high baseline, and then vow to bring the price up to triple-digits. A minor rally follows, at which point they ramp up their exports, while US shale output also soars. At this stage OPEC, non-OPEC and shale producers start pumping and exporting like crazy, while reporting high compliance, and the price plunges once again.”
While overly bearish, this point of view does reflect some of the problems inherent in such agreements. Lawrence agrees that overstating the level of curbs, and hiking exports during a production are common tricks, although he is reluctant to overestimate their significance.
“There is some truth to that,” Lawrence conceded. “It’s certainly not as optimistic as the headlines suggest, and countries providing a higher starting point for cuts is definitely something that we have observed in this period. But the question is, if none of the cuts had been agreed, how far would we have seen oil price drop?”
The analyst pointed to one factor that has taken the cartel by surprise – the dramatic decline in the cost of production in other areas, such as Canada and the US. While they still have a higher breakeven point, it has fallen quite significantly from even a couple of years ago.
“I would argue that shale is the main story here, in that we continue to see very strong supply from those producers as their production costs drop. There is understandable scepticism in the market about OPEC’s ability to give a meaningful boost to the price. I don’t think that they can achieve a level of cuts that could push it into the US$70 range, although the curbs at least have helped to provide a base to the price.”
Most experts agree that the recent market dynamics are reflective of OPEC’s waning influence and the rise of more peripheral players ushered in by the shale industry. At this stage, the cartel finds itself in a lose-lose position, where any move is going to have a negative impact – and has to choose the lesser of many evils. Cutting production further to prop the price incentivizes the shale producers to gnaw at its market share. Deepening the curbs may help in the short term, but could result in a price crash when the cuts end.
Speculative traders are adding further volatility to the market.
“We are seeing these sharp momentum swings, followed by momentum-driven accounts jumping on those moves, resulting in sharp retracements in both directions. So the speculators’ role in these market dynamics is growing, particularly in short-term movements.”
Still, the current measures are expected to provide short-term relief, with most experts predicting a price range of US$45-55 for the rest of the year, with a tentative hope of passing the US$60 mark in 2018 – barring a significant rise in tensions in the Middle East, which could lead to a supply drop.
A subdued oil price will have a varied effect on emerging markets. For Mexico, for example, low prices raise the importance of the energy reforms and the need for more FDI to support the oil industry, which has seen both prices and production fall dramatically.
“It really is question of whether the country is a net importer or exporter of oil. Somewhere like Colombia will struggle a lot more than somewhere like Turkey, which is still a net importer,” Lawrence noted, adding that their expectations on global growth – and thus growth in oil demand – is reserved, forecasting it to stay around the same level as current.
But the bigger questions – not addressed at the OPEC meeting – persist. How long can the cartel continue extending the cuts? How will it ensure high levels of compliance? Will it tackle the rising exports issue? Will it find a way to coexist “peacefully” with the increasingly powerful shale industry?
The longer it continues to sweep these problems under the rug, the more likely both OPEC and non-OPEC producers are to be in for a rude awakening come 2018.