Note to OPEC: Be Careful What You Wish For...
April 23, 2018
Last Friday (April 20), the Joint Ministerial Monitoring Committee (JMMC) of the OPEC/Non-OPEC Alliance met in Jedda, Saudi Arabia, to assess the impact of the alliance’s production freeze effort and review the state of the global oil market in anticipation of the group’s upcoming meeting in June. The session followed the release of a number of analyses, including those of both the International Energy Agency and the OPEC Secretariat, affirming what many market analysts have been privately saying for weeks, namely that the long awaited global oil rebalancing is essentially already here. In fact, some would argue that after factoring in new pipeline and storage infrastructure (now part of minimum operating inventory) and using a variety of metrics (e.g., days of forward cover), we are already below the target level and in danger of overcorrecting and overtightening.
With oil prices now at three-year highs (Brent opened just under $74 per barrel this morning), new reports suggesting discussions of both an extended “freeze” (beyond this year) or even additional cutbacks prompted President Trump to tweet that prices were now “artificially” high, presumably as a consequence of the alliance’s actions, although on any given day, market sentiment can also be impacted by a variety of factors including national policies and events. The president’s challenge resurrected the ongoing debate about the pros and cons of attempting to manage the oil market and highlighted the unfamiliar position in which the United States now finds itself: being both a large consumer and, increasingly, a major producer of oil.
On the market management point, there is no doubt that the actions taken over the course of the past year by the (now 24-member) OPEC/Non-OPEC Alliance (along with robust demand and a spate of planned and unplanned supply outages) have effectively reduced the once excessive oil inventory overhang to “normal” levels and thereby restored some semblance of order to the market. With the objective of the alliance’s “freeze” (i.e., the reduction of global stock levels to the historical five-year average) now presumably achieved (or on the cusp of being achieved), more recent discussions have pivoted on the dual notions of ensuring that the oversupplied/surplus imbalance can be avoided in the future, even as producers seek a price substantial enough to warrant new upstream investment longer term. (For an expanded discussion on why the historical five-year stock average is an outdated proxy for market balance, please see the CSIS Commentary, "Bulls and Bears Converge," from June 29, 2017.)
Beyond the issue of market fundamentals (i.e., supply, demand, and inventory as the “balancer”), however, is the role that sentiment also plays in today’s pricing decisions. Buttressed by concerns over next steps in Syria or North Korea, the prospects for sanctions against Russia and Iran, and geopolitical risks associated with the recent Houthi attacks on Saudi Arabia or ongoing turmoil in Venezuela, Nigeria, Angola, Libya, and Iraq, net length of managed money is near record levels as events continue to weigh on markets and investors, at least for now. Events of the coming weeks/months (aptly referred to by our friend and colleague Ed Morse as the “Maydays”), including elections in Turkey, Iraq, and Venezuela, the upcoming decisions related to Iran sanctions and the fate of the Joint Comprehensive Plan of Action, and potential meetings with North Korea, etc., could well reverse these positions.
On the domestic, political front, the president is right to worry about the impact of rising crude oil and gasoline prices just prior to the onset of the summer driving season and the implications for disgruntled consumers as they enter the fall elections. Despite the talk of energy dominance, the United States still consumes roughly 20 million barrels per day of oil/liquids and continues to be a significant importer, in spite of increasingly setting new records for domestic oil output (now above 10.4 million barrels per day). Higher prices are good for producers and infrastructure investment, but they have offsetting consequences for consumers at large.
Recognizing the contributions that lower energy costs have made to global economic growth over the past few years, India also recently warned OPEC of the adverse economic consequences of (substantially) higher oil prices. And while it is true that at reduced production levels, OPEC collectively now retains between 2 and 3 million barrels per day of excess or spare production capacity, the prospects of sabotage, political or civil unrest in the Middle East, Africa, or Venezuela, coupled with sanctions, could render those volumes inadequate or inaccessible. U.S. light oil is a poor substitute for middle grade barrels, and national/strategic reserves are unlikely to provide either immediate or long-term offsets to large-scale disruptions. Higher prices would undoubtedly bring new projects online, but investments and logistical constraints take time to translate into deliverable barrels.
Last week, Energy Minister Khalid al-Falih of Saudi Arabia, contrary to media reports that seemed to focus exclusively on OPEC’s aspiration for higher price targets, articulated a more balanced and nuanced view of both the opportunities and challenges ahead. On the one hand, Minister al-Falih reiterated that market participants require higher prices to warrant new investments in large-scale projects in order to avoid an impending supply “gap” spawned by years of systemic underinvestment. At the same time, he sought to calm markets by assuring that Saudi Arabia and its partners would continue to monitor and “manage” the market, presumably by adding or withdrawing supply as conditions warrant. He “welcomed” the addition of U.S. oil volumes even as he acknowledged the precarious nature of some less-resilient production sources globally. Left unsaid was the market’s impact on the timing of Saudi Aramco’s initial public offering and how that might play in the kingdom’s strategy going forward.
For the past few years, OPEC has been singularly focused on eliminating the enormous supply overhang, but with the golden ring now in sight, a new adversary potentially sits just over the horizon—and this one comes in the form of under (rather than over) supply and can be exacerbated, if not caused, by premature or excessive overtightening of production output. Recent alliance deliberations have necessarily targeted maintaining compliance with output cuts and working off excess stock surpluses, although at $70 per barrel prices, U.S. producers are already hedged into 2019, raising prospects for recreating a surplus next spring. Upcoming discussions should nonetheless include (at least in terms of contingency planning) a mechanism for unwinding or relaxing the current agreement and making ready to resupply markets in the event of large-scale disruptions or imbalances.
Producers who fail to appreciate the combined and detrimental impacts of a sustained assault on fossil fuel output for climate reasons with the potentially dramatic and adverse economic consequences of and consumer reactions to volatile and precipitous increases in oil prices do so at their peril.
Frank Verrastro is a senior vice president and trustee fellow with the Energy and National Security Program at the Center for Strategic and International Studies (CSIS) in Washington, D.C. Sarah Ladislaw is a senior fellow and director of the CSIS Energy and National Security Program. Guy Caruso is a senior adviser with the CSIS Energy and National Security Program. Larry Goldstein and Albert Helmig are senior associates with the CSIS Energy and National Security Program.
Commentary is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).
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