OPEC cuts yet to shift market

One month in to its agreement to cut production, OPEC has managed to achieve a high level of compliance. For the countries that are party to the agreement, they managed to cut collective output month on month by 1.06m b/d in January, coming close to full compliance with the targeted output level. Previous deals to limit output have been plagued by generally poor adherence by OPEC members as producers have incentive to cheat if prices do rise and face little consequence if they over-produce. With only one month down out of at least six, it will still take some time to determine if cutting production was indeed the right strategy to help balance markets.

Collective compliance appears high but the distribution between OPEC members is varied. Saudi Arabia has taken a larger than required cut (598k b/d from its baseline level compared with 486k b/d required by the agreement), once again playing the role of a swing producer. Angola also 'over-cut' although we would expect this to reverse as new oilfields will come online ahead of schedule. Qatar, Kuwait and Algeria all came close to hitting their cut targets and we would expect compliance to remain strong among the GCC producers. Iran also contributed to limiting output by missing the higher level it was allowed to reach.

However, some producers have ground to make up. Most notable is Iraq where output fell 85k b/d, compared with its target cut of 210k b/d and the UAE where output fell just 82k b/d from baseline levels compared with pledged cuts of 139k b/d. The UAE's under-performance in this regard follows on from production hitting a plateau at the end of last year and plans to hit mandated levels as an average over the duration of the agreement, rather than in one month. 

Has OPEC cut too much too soon?

On aggregate, OPEC managed to remove more than 1.35m b/d from the market from its baseline level, although the size of the cut is just 441k b/d when including the output of Nigeria and Libya who have been excused from the deal. The size of the initial cut, however, and burden that Saudi Arabia and some of its partners in the GCC have taken in absorbing most of the cuts makes us cautious about whether sustained month-on-month declines in production can be achieved. OPEC has set a rod for its own back to ensure production stays at the current low levels as for many producers the only direction of travel would be higher. Even in Saudi Arabia, where we would expect the highest degree of compliance with the deal, production may start to climb from April in line with seasonal trends of higher oil demand in the summer months.

The oil market has held reasonably steady so far in 2017 with Brent futures trading in a range between USD 54-58/b. The level of OPEC compliance has served to reinforce this range, rather than push prices higher, which highlights to us the importance of factors beyond OPEC's monthly production levels. 

Output from non-OPEC producers, particularly other national oil companies—in Russia, Mexico or Oman for example—had been pledged to decline in coordination with the OPEC deal and so far signs are good that some major producers are following suit. Russian production fell 100k b/d in January, its largest decline since August, meeting slightly less than a third of its agreed cuts. Data out of Oman has yet to be released but we would expect at least some initial compliance in line with its GCC peers.

The paucity of data coming from OPEC and other NOC producers means that some of the direction for prices is surrendered to the nearest available source of oil market data: the US. Crude production there has been on a consistently upward trend since October 2016 and is now within sight of hitting 9m b/d. The outlook for US production has also been steadily revised higher: the EIA has recently revised up its forecasts for production in 2017 and expects output to average around 9m b/d—which looks to be an underestimate in our view. Producers in the US had been able to take advantage of a generous contango structure in WTI to hedge forward production and the potential of changes to corporate tax structures in the US may see WTI surge to a premium over Brent, potentially extending the timeline for production growth from the US.

Inventories yet to give ringing endorsement of OPEC deal

While OPEC has little control over whether other oil producers limit their own production, a key objective of the deal was to help markets rebalance by forcing a drawdown of the excessive inventories that have built up in crude and product markets since 2014. Data from IEA showed that OECD inventories were indeed tempering at the end of 2016 although they were still at exceptionally wide levels when compared with their five-year averages.

OECD inventory data is only available on a monthly basis, and with several months delay, meaning that full January inventory figures won't be available until March from the IEA. That leaves market surveys of stockpiles as the most readily available indicator and looking to the US, the numbers are pointing in the wrong direction. US crude stocks have built steadily in 2017 and are now within sight of re-touching their maximum level of 512m bbl. Beyond the overall level, the trajectory of inventories has been steadily higher, including the second highest weekly build ever—13.8m bbl—reported in early February.

European inventories give an impression of a tighter market than their level for most of 2016 although the weekly numbers are highly choppy. Gasoil (diesel) futures for delivery in in the ARA region remain in contango which would give an indication of ample inventories. Gasoil time spreads have narrowed from their wide levels in late 2015 but the contango appears to have stabilized since about the middle of 2016.

A flip of the oil futures curve into a more assured backwardation would send a stronger signal that inventories are indeed tightening at a fast pace and curbing the excess in the market. So far December Brent spreads for 2017 into the next two years have flipped into what we could describe as a tentative backwardation, holding below USD 1.50/b. Prior stretches of backwardation saw long dated spreads as wide as USD 11/b. If indeed the backwardation deepens thanks to rising near term prices (against which OPEC producers price their exports compared with independent producers who are more likely to hedge further down the curve) then we could more confidently view the OPEC deal to cut output as a success.

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