OPEC, Saudi Arabia, and Sanctions Update: Connecting the Dots

Facts:

• At a meeting in St. Petersburg, Russia, on July 24, the Organization of the Petroleum Exporting Countries (OPEC) agreed to retain the ongoing production freeze with a few modifications.
• Export data rather than reported production volumes will now be used as a metric for determining compliance with the production agreement.
• Nigeria, exempt from the original agreement, but now in the process of ramping up production, agreed to join the pact once its production “stabilizes” at 1.8 million barrels per day (mmb/d). Production averaged 1.4 mmb/d during the first quarter (1Q) of 2017 and has been steadily rising, until last week’s attacks against infrastructure reduced those gains.
• Libya, also exempt, has managed to raise production from under 0.7 mmb/d in 1Q 2017 to close to 1.0 mmb/d currently but shows no signs of agreeing to a ceiling.
• Russia continues to support the framework, and exports from Russia have recently dropped to offset production gains in Kazakhstan and Azerbaijan.
• Saudi Arabia unilaterally announced that it will limit its (crude oil) exports to 6.6 mmb/d, a significant reduction from recent levels.
• At the same time, the Trump administration and Congress have moved to enact sanctions against Russia, Iran, and (individuals within) Venezuela—all of which carry implications for oil markets, prices, and investment and consequently require some explanation and context.

Opinion:

OPEC’s efforts to boost compliance were the predictable result of issues facing the cartel that were outlined in our June 29 commentary: “Bulls and Bears Converge: Sentiment Shifts and Misperceptions in the Oil Market.” In attempting to reverse previously bearish market sentiment, OPEC had no option but to continue to observe the ongoing production freeze and hope reduced supply and resurgent second-half 2017 demand would accelerate the drawdown in global stocks and bring forward the long-awaited market rebalance.

From the Saudi perspective, moving the focus of the agreement to exports rather than production data makes imminent good sense. First, domestic use of crude oil (typically on the order of 300–800 thousand barrels per day (kbd)) for direct burning for power generation increases materially during the summer months. Assuming a production target of 9.6 mmbd and subtracting out domestic refinery needs of 2.5 mmbd (plus or minus) leaves approximately 7.0 mmbd of oil available for export. If summer burn requirements are met from a combination of domestic production and withdrawal from inventory, even peak domestic “summer burn” usage can easily be accommodated while adhering to the 6.6 mmbd export target.

In addition, so long as exports are the focus for compliance purposes, higher production levels within the kingdom during this period can be diverted to replenish domestic storage—where it is not a threat to global supplies, but handy if needed for an emergency. Finally, to the extent Saudi and OPEC officials have been focused on demonstrating material reductions in U.S. storage levels (to stabilize and increase prices), reduced exports to the United States during this period will also go a long way to directionally accomplishing this objective.

An OPEC monitoring committee meeting has been set for August 7–8 in Vienna. Technical representatives from Kuwait, Russia, and Saudi Arabia will share information on the market outlook and expectations for the pace of rebalance across the next few quarters. In our view, OPEC members still have more reason to support an agreement than to ignore it. U.S. production growth may be starting to slow, the global economy (and oil demand) is still on a reasonable upward track, and geopolitical events in places like Venezuela may yet remove barrels from the market.

The recent flattening of the forward curve and prices above $50/b have once again drawn interest in hedging future production. This could spur drilling activity in 2018. While oil price pathways for the remainder of 2017 and into 2018 remain uncertain, we still believe that, absent a major disruption, prices will remain range-bound near current levels with an undulating pattern reflecting fundamentals, sentiment, geopolitical events, and sanctions. In our view, sentiment has often been driven by isolated events, while the underlying trends in the market have been a function of the totality of market and policy movements. Connecting these “dots” remains the key to understanding and interpreting future market activity.