Era of ‘lower for longer’ oil prices won’t end with OPEC’s intervention

The direction of the oil price can never be ignored by the natural gas industry given black gold’s influence on investment patterns within the wider hydrocarbon sphere. The last two years have been particularly rocky for the oil market given the abundance of crude.

In July 2014, Brent was trading above $115 per barrel, but by late January 2016 the world’s preferred price benchmark had fallen below $28. Seeing a rapidly growing supply glut in November 2014, the Organization of Petroleum Exporting (OPEC) decided against living up to its ‘cartel’ tag and opted to defend its market share by ramping up production to record highs. Russia, a major non-OPEC producer, did likewise.

The hope was to knock marginal oil producers, especially US shale explorers, out of the game. End result was a whole lot pain in the industry, declining prices and burgeoning inventories. By some measures, almost half a trillion dollars worth of final investment decisions (FIDs) were put on ice by international oil and gas companies and state-backed energy giants alike.

Yet, US producers proved more resilient than many observers, not just OPEC, had anticipated in an era of ‘lower for longer’ oil prices. Confounding observers, viable US shale plays remained onstream even below $30.

Flame

Question at the back of everybody’s mind is – what will the average oil price be over the course of 2017, and will the crude market rebalance sooner than expected? Faced with such vexing questions and its own internal rumblings, OPEC reversed its stance of keeping the taps open on November 30, 2016 and announced a production cut of 1.2 million barrels per day (bpd); its first reduction in eight years.

The move, effective January 2017, would take OPEC’s headline output down to 32.5 million bpd. Bulk of the reduction would come from Saudi Arabia, which would account for 486,000 bpd. Additionally, ten days on from OPEC’s decision, selected non-OPEC producers, including Russia, reached a pact with the cartel for the first time in 15 years, and announced 558,000 bpd in cuts of their own.

Predictably, oil futures languishing in the $40s spiked above $50, with Brent capping $55 at one point. Afterall, put together, a 1.76 million bpd cut would accelerate a rebalancing of the market. However, when it comes to the announced cuts, the devil is in the detail. Both pacts, inked internally within OPEC and its deal with non-OPEC participants, are not legally binding agreements, but one reached on good faith.

Both sides have a very poor record of honouring such commitments. The market would be looking closely at figures on cargo dispatches – most notably those provided by data aggregators S&P Global Platt’s and Argus – early in 2017 to note whether the oil producers involved have kept their word.

Any hint of a broken promise within OPEC would see others break ranks and pump more. If the Saudis lose patience, the whole thing is off. As for the announced non-OPEC cuts, these would be even harder to police and question marks remain on whether the said levels represent real-term cuts or an exercise in inventory rebalancing.

As investment bank Goldman Sachs noted: "The [non-OPEC] agreement is noteworthy as it lifts the uncertainty on the potential participation of non-OPEC producers to the OPEC cut...Ultimately, this remains a short duration cut in our view, targeting excess inventories and not high oil prices."

Nonetheless, the ability of Saudi Arabia and Russia to come to an agreement given the current state of the oil market has to be seen as a significant statement of intent, one that sentiment-driven futures traders would find hard to ignore for the moment.

So for the first quarter of 2017, a climb upwards to a $60 oil price – the average peak level for 2015 – seems about right. However, after achieving that level, there would be relatively limited upside. US shale producers, some of whom have aptly demonstrated their resilience at $30, would put fresh hedging strategies in place, to keep themselves in the game and ramp up production.

From a supply standpoint, that is something OPEC and Russia can do little about. As the US Energy Information Administration recently noted: “A price recovery above $50 could contribute to supply growth in US tight oil regions, and in other non-OPEC producing countries that will not participate in the OPEC-led supply reductions.”

Furthermore, viable shale plays staying the game is one thing. Anything above $50 will almost certainly result in increased investment by US exploration companies, especially those operating in the Permian Basin in Texas and New Mexico.

Therefore, once the dust has settled, the oil price may fall back to $50 and lurk around that level towards the middle of 2017. Given that demand growth forecasts are nowhere near 2013-14 levels, before the price slump ensued, all OPEC has done is make a slide below $40 less likely in 2017.