Oil: Higher probability of a cut, still low odds of success

Recent comments by Saudi Arabia and Russia point to a greater probability of a production cut, although higher production from Libya, Nigeria and Iraq are reducing the odds of such a deal rebalancing the oil market in 2017.

The post-Algiers rally in oil prices has continued, fueled by comments by Russia and Saudi Arabia today (October 10) that point to a greater probability of reaching a deal to cut production. Saudi Arabia likely holds the reigns to such an agreement, with signs of elevated funding stress potentially driving Saudi to commit on November 30. As usual, risks of a disagreement are not negligible with Iraq currently the most vocal opponent, aiming to grow production next year and disputing usual measures of its production as too low. Failure to reach such a deal would push prices sharply lower to $43/bbl in our view as we forecast that the global oil market is in surplus in 4Q16.

Beyond the uncertainty on this Saudi shift, the odds of a successful implementation remain low at this point of the oil market rebalancing. We see price-insensitive upside risks to global oil production from (1) the likely poor compliance from noncore OPEC producers, (2) the countries exempt from such a deal (Libya/Nigeria/Iran) which are currently producing 500 kb/d more than we expected, and (3) the wall of supply coming online outside of OPEC in 2017 with 40% more new projects than in 2016. Any of these three forces is sufficiently large in our view in 2017 to make the required cut in Saudi production too large to improve the current funding stress, making the shift in policy premature in our view.

If the deal is reached, strictly implemented, with no upside to our conservative disrupted production and new non-OPEC projects forecasts, we would expect priceinduced responses to gradually offset the OPEC production cut next year: (1) The aging US shale well profile is stabilizing production and as a result higher prices will allow for a rapid ramp up in production in 2017. (2) Demand growth will remain resilient in our view but the historical activity and price sensitivities suggest less growth at higher oil prices. (3) Legacy production declines have remained limited outside of China, Venezuela, Colombia and Mexico as producers seek to maximize cash flow from existing production (so far, shale declines and short-term disruptions have each been a bigger driver of the oil market rebalancing than low price induced production declines). At slightly higher prices, we would expect a ramp up in shortcycle brownfield investment to further reduce legacy declines.

As a result, assuming that a production cut not only occurs but is successfully implemented with no offsetting price-insensitive supply shifts, we believe that an initial recovery in prices and fundamentals would progressively be undone. In the instance where a deal is reached but its production impact is offset by price sensitive sources of supply, we would expect our 2017 WTI price forecast of $52.5/bbl to hold, although with prices initially higher than we expect (1Q17 at $45/bbl) but in turn lower prices later in the year than we expect (4Q17 at $60/bbl) as non-OPEC production reacts to the higher prices now. In fact, the momentum on this supply response would likely require a renewed cut in OPEC production in 2018, at which point the volume loss would more than offset the price recovery.

Net, we find that an agreement to cut production, while increasingly likely, remains premature given the high supply uncertainty in 2017 and would prove self-defeating if it were to target sustainably higher oil prices.

Damien Courvalin, Jeffrey Currie, Abhisek Banerjee, Chris Mischaikow – Goldman, Sachs & Co.