OPEC’s choices: double down or do nothing

May 12th, 2017 | By | Category: Commodities

By Nitesh Shah, commodity strategist at ETF Securities. ETF Securities is a specialist provider of single and broad market commodity ETPs.

Nitesh Shah, Commodity Strategist at ETF Securities

Nitesh Shah, commodity strategist at ETF Securities.

OPEC’s current strategy is not working. Oil prices have given back nearly all their gains since the cartel agreed to cut production in November 2016. We believe the credible options for their next move, to be discussed at their May 25th meeting, will be to either to cut deeper or let the deal collapse. The latter option seems the most likely outcome.

As we argued in our recent outlooks, the efforts of OPEC members with assigned quotas, are being undermined by:

  • the growth in supply from the OPEC members who don’t have quotas
  • non-OPEC members participant to the deal that are not adhering to it
  • the rapid growth in supply from other countries, most notably the US

Today’s release of OPEC’s Monthly Oil Market Report acknowledges the extent to which supply from the US, Canada and Brazil is set to rise.

We therefore believe that repeating the same strategy for another six months will do little to shore up oil prices. OPEC nations have given up market share and have barely reaped any price gains. Given that consensus expectations are for a simple deal extension (i.e. that is what is currently priced-in), following the status quo is unlikely to be met with a positive price response. We believe that if OPEC is serious about getting the market to balance it will have to cut deeper in order to ‘shock’ the market and drive prices higher. Sacrificing volume requires higher prices.

However, gaining a consensus agreement on a bolder move will be difficult. The smaller and more financially constrained members will be reluctant to give up more volume. Saudi Arabia is vocally supportive of a deal extension. But if Iran insists on being able to increase production further while Saudi Arabia has to bear the brunt of further production cuts, the deal’s flaws will become even more accentuated. We believe that doing nothing and letting the deal collapse will be default option in the event that the cartel is unable to gain support for a deeper cut.

While OPEC surprised on the upside at its November 2016 meeting by coming to an agreement, we believe the May 25th 2017 meeting will surprise on the downside with a lack of agreement. In such event, oil prices could decline close to $40/bbl (from $48/bb currently), which we believe is the structural floor for oil prices, set by the breakeven price of US shale oil production.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)

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