Yesterday OPEC affirmed our base case of a cut being struck at the 171st OPEC meeting in Vienna. The OPEC-14 has decided to reduce production by a total of 1.2Mb/d limiting production to 32.5Mb/d, effective January 1, 2017 for six months with an option to renew if no opposition. The burden will be shared equitably across members (“adjustments”, not quotas), with the exemption of Libya and Nigeria. Notably, Iran has agreed to freeze production at 3.797Mb/d and Iraq shall reduce production by 4.5% (209kb/d). Indonesia was allowed to suspend their membership, because they could not participate in the decision due to their position as a net importer. Russia also agreed to cut 300kb/d. OPEC plans to hold meetings with non-OPEC nations for further cuts on Dec 9th.
Historically, OPEC compliance with proposed cuts has been about 60-75% of agreed volumes, with not-so-subtle cheating coming from Angola, Libya, Iran, and Nigeria. Though compliance is hard to enforce, we can theoretically expect a realized cut of .9 – 1 Mb/d from OPEC.
Their intent of this cut is to accelerate the drawdown of the stock overhang. As such, this cut is likely to have a large influence on not only the outright price of oil, but also the shape of the curve. With these cuts, the market will flip into a deficit starting February 2017, eliminating the entire inventory build of 2016 by the end of next year. I believe that in complying with a cut, OPEC is looking to flip the crude oil curve into backwardation, keeping prompt prices at a healthy target of $60 while keeping forward prices depressed at (or below) $50 a barrel. This is especially needed as OPEC’s constant verbal intervention has lifted crude prices and stimulated domestic US shale investments. 2017 West Texas Intermediate calendar swaps have averaged $50.60 since June allowing diligent producers the opportunity to hedge new and existing production; and current guidance from numerous shale producers is indicating a growth of 300kb/d over the course of 2017. Backwardation will ensure that the rate of shale production growth remains sluggish, allowing OPEC to increase production when future demand arises.
Our Brent forecast remains the same… We believe this outcome solidifies the $40-$45 lower band and increases the probability of tail risk to the upside. Brent is likely to exit the year between $50 and $55, and average $65 and $75 in 2017 and 2018 respectively. In the coming days and weeks, the market will be looking for clarity on county specific quotas, duration of production cut, restraints around exemptions, and non-OPEC involvement if any.
Now that OPEC has agreed on an internal cut, they are moving to solidify a cut from non-OPEC of about 600 kb/d. Much of the burden is likely to fall on Russia, Oman and Azerbaijan, who at one point have expressed interest in joining OPEC in reducing production. Any added cooperation from these countries will be taken positively by the market; however Russia has a poor history of compliance.
My forecast below outlines my expectations for price, with a base case of oil prices exiting 1Q17 between $50-$60 a barrel. Positive and negative tail risks to be monitored are:
Positive Tail Risk
Negative Tail Risk