The Fuse

OPEC’s Perennial Rebalancing Act

by Nick Cunningham | November 13, 2019

The prospect of a renewed supply surplus in 2020 presents OPEC with a familiar conundrum. Should the group cut output once again, shouldering additional burdens in an effort to prop up prices and rebalance the market?

Letting the production cuts expire is off the table, as it would send prices spiraling downwards. Cutting deeper is likely too big of a lift. The most likely outcome, then, is an extension of the current cuts. But that does not mean that there won’t be drama at the upcoming meeting in Vienna.

OPEC+’s perennial rebalancing act
The OPEC+ coalition has been engaging in some sort of production curtailment for the better part of three years. The long sought-after “rebalancing” of the oil market is perpetually just out of reach, forcing the group to extend again and again.

Ministers will gather in Vienna in a few weeks to go through the motions yet another time, likely extending the production cuts through the end of 2020. Major oil forecasters – the EIA, IEA and OPEC itself – have repeatedly downgraded oil demand growth this year, and weakening demand will likely translate into a supply surplus next year.

The elephant in the room in Vienna will be the Saudi Aramco IPO.

However, there are still some interesting wrinkles worth exploring in the lead up to the OPEC meeting. The elephant in the room in Vienna will be the Saudi Aramco IPO, which will be launched within days of the OPEC meeting. There is a litany of risks and questions surrounding the offering and the valuation of the company, but one of the key ingredients in obtaining a lofty valuation is the price of oil. Riyadh has an interest in preventing a slide in oil prices, and press reports have suggested that OPEC might even explore deeper cuts.

However, there are several reasons why that likely won’t happen. Engineering a deeper production cut might boost prices, but it would also highlight the political risks that investors face when buying stakes in Aramco.  Meanwhile, Russia has never been all that keen on cutting deeper, and Moscow is less squeamish about lower oil prices than Riyadh. The challenge of getting every oil-producing member onboard with the initial agreement was tricky. Deeper cuts will be much harder to obtain from member countries suffering from budgetary constraints and competing incentives and political goals.

Perhaps just as important is the fact that OPEC likely recognizes the cracks forming in U.S. shale. After years of blistering production growth, even during periods of low oil prices, the debt-fueled drilling boom is finally losing steam. Investors have soured on the entire sector, and capital is becoming harder and harder to obtain for embattled American drillers.

The latest results from the third quarter earnings season offered further evidence of a slowdown. More than a few companies are cutting spending, sidelining rigs and taking a more cautious approach to drilling.

With U.S. shale finally on the ropes, now is not the time for OPEC to rescue them.

Cutting deeper would throw a lifeline to U.S. shale, which has been one of the main critiques of the OPEC+ cuts in the first place. “There is always a risk that if we cut deeper and prices rise, those [U.S.] companies could change their plans to hike production,” a Gulf OPEC delegate told the Wall Street Journal. “OPEC would ensure that won’t happen,” he said. With U.S. shale finally on the ropes, now is not the time for OPEC to rescue them.

Oil risk skewed up or down?
There is still some work to do in Vienna, however. Saudi Arabia will likely lean on some laggards to step up their compliance with the existing deal, such as Iraq and Nigeria. That could help tighten up the market without needing to build consensus for a new deal.

Despite a general consensus that the oil market is facing oversupply in the next few months, there are still a range of opinions on what to expect as 2020 wears on. The global economy could continue to decelerate, even as recent data has eased concerns.

Several investment banks have warned that if OPEC does not cut deeper, oil prices could fall. Citigroup and BNP Paribas says oil could fall to the low-$50s. Morgan Stanley says oil could fall even farther. “The prospect of oversupply looms over the market in 2020,” said Martijn Rats, global oil strategist at Morgan Stanley, according to Bloomberg. “Either OPEC deepens its cuts, or prices will fall to about $45 a barrel, and force a slowdown in U.S. shale that balances the market.”

OPEC itself sees the looming glut as less serious than previously thought.

On the other hand, others say the downside risk could be overblown. OPEC itself sees the looming glut as less serious than previously thought. A breakthrough in the U.S.-China trade war could also throw some of the bearish scenarios out of the window. 

Goldman Sachs says that shale drillers are being starved of capital, companies themselves are becoming more disciplined, and mixed productivity data point to lower-than-expected supply growth. The unfolding slowdown in U.S. shale could be a pivotal factor that leads to an inflection point in the oil market – as shale output stagnates, the market could tighten and prices could rally by 2021. 

While demand is slowing, so too is supply growth.

In other words, while demand is slowing, so too is supply growth. The IEA said in its October Oil Market Report that the U.S. would add another 1.3 million barrels per day (Mb/d) in 2020, following the 1.6 Mb/d it sees adding this year.

But this is now one of the more optimistic forecasts out there. Goldman Sachs put supply growth next year at just 0.6 Mb/d. Some shale drillers themselves are even more downbeat. “At a September investor conference, I predicted that 2020 total U.S. year-over-year oil growth would be 700,000 barrels per day which at that time was considerably below consensus,” Mark Papa, CEO of Centennial Resource Development, said on an earnings call earlier this month. “Given additional data I now think that 2020 year-over-year oil growth will be roughly 400,000 barrels per day which is below current consensus.”

In short, OPEC+ may be forced once again to extend the production cuts when it meets in a few weeks’ time. But the pain in the U.S. shale industry will make its task of rebalancing the market just a bit easier.