The OPEC cartel is poised to slash crude output after weeks of feverish shuttle diplomacy by Saudi Arabia, halting the “pump and dump” price war that has ravaged the oil industry for two years.
Officials from the cartel’s 14 member states will gather in Vienna today to start hammering out the final details of a deal to clear the enormous surplus hanging over the market.
OPEC talked themselves into a corner and they have to come away from Vienna with something
They have received quiet assurances from the Kremlin that Russia will play its part by freezing production.
“OPEC talked themselves into a corner and they have to come away from Vienna with something,” said David Fyfe, market chief at oil trader Gunvor.
“Prices could easily fall below US$40 again if this ends without a deal. They need to cut by at least 1 million barrels a day (b/d) to eat into inventories in early 2017. But it will be tricky: the Saudi red line is that they are not going to do this alone, and there must be some ‘buy-in’ from the others,” he said.
Yet any breakthrough will come as the U.S. Geological Survey reports vast quantities of cheap shale in the Wolfcamp pocket of the Permian Basin of West Texas, and US president-elect Donald Trump vows to slash costs for drillers and open federal land for exploration.
The Permian alone could rival the giant Ghawar oil field in Saudi Arabia, ultimately producing 6 million b/d at relatively low cost.
OPEC faces a Sisyphean task. It must learn to live with a permanent threat from agile frackers in North America, who are able to crank output within months at ever lower break-even costs, potentially capping global crude prices at half the level of the long boom years, which ended so brutally in 2014. Brent crude nudged up to US$46.80 last week on optimistic talk from OPEC ministers, though prices are still down 15 per cent since early October.
There have been hints of a loose agreement that lets Iran and Iraq curtail output slightly above current levels, leaving the Gulf states to do the heavy lifting.
“If they are highly disciplined and it doesn’t all fall apart as everybody cheats, prices could climb back up US$60 next year, but that is a very big if,” said Mr Fyfe.
Suspicions abound that several countries are inflating production figures to lock in a higher ceiling.
“Basically, there is going to be a deal,” said Ole Hansen from Saxo Bank. “Shale is now so lean and mean that OPEC can’t count on U.S. production falling. They’re only hurting themselves if they continue to pump and dump.”
OPEC reached a political accord in September to cut supply to a band of 32.5 million -33 million b/d, vowing to flesh out the details by Nov 30. Failure to do so would be the final nail in the coffin for the shattered credibility of the cartel.
Yet everything has gone the wrong way since then. OPEC produced a record 33.8 million b/d last month, and the immediate glut is getting worse. Shipments from Libya and Nigeria have together jumped by about 1 million b/d since mid-summer as attacks on oil infrastructure abate and ports return to business.
Iraq is reopening a pipeline in the Kirkuk area, and aims to boost output by another 300,000, insisting it should be exempt from cuts while it battles Islamic State of Iraq and the Levant (Isil).
Iran is back to pre-sanctions levels and is preparing to open three new fields with a further 200,000 b/d.
Twisting the knife deeper, the U.S. is still drilling extra wells. The latest Baker Hughes rig count rose by two to 452 last week.
Frackers have sold forward their production with hedge contracts, guaranteeing future supply whatever now happens. “They took advantage of the window for a few weeks when oil was higher and locked in hedges of around $52 for 2017, and $55 for 2018,” said Mr Hansen.
Esther George, the head of the Kansas Federal Reserve, told an oil forum on Friday that the average price needed by shale drillers to make a profit has fallen from US$79 to $53 in two years as technology matures, and many are making money at prices well below that.
She had a warning for those who expect a return to business as usual in global oil markets, predicting that a “large amount” of production would come on stream as soon as prices push through the mid-US$50s.
“I do not see much room for price appreciation,” she said.
Markets have grown cynical about OPEC rhetoric on cuts. Yet it is increasingly clear that Saudi Arabia has genuinely reversed course under the new energy minister, Khaled al-Falih, and this has changed the character of the Vienna meeting entirely.
The Kingdom can no longer afford to fight a gruelling war of attrition to force rivals out of the market.
While it has succeeded in killing off US$200 billion of investment in deep-water projects, Canadian tar sands and other high-cost ventures, this has come at a very high price.
The Saudis have been burning through foreign exchange reserves at a rate of US$10 billion a month, and contrary to general belief, their usable reserve buffer is relatively thin. They face an internal banking and liquidity squeeze and a construction crash, and have had to tap the global bond markets on a large scale to pay their bills.
“The Saudis are the ones that have suffered the biggest hit in revenue and face the most financial pain, and it has gone on a lot longer than they ever anticipated,” said Mr Fyfe.
Austerity policies are biting in earnest, threatening the social contract of cradle-to-grave welfare that underpins the Wahhabi regime. Cuts in salaries, and perks and allowances have reduced take-home pay for lower-level state employees by as much as 60 per cent.
Intelligence analysts say the Saudi-led war in Yemen is proving far more expensive than admitted, suggesting that budget deficit is significantly higher than the official figure of 13 per cent of GDP. It recently emerged from Pentagon papers that the Saudis have lost 20 of their state-of-the-art Abrams tanks.
Helima Croft from RBC says the Saudis are now throwing their full diplomatic weight behind the search for a deal, though markets have not yet grasped the significance of this. If the Saudis want a deal, a deal is what will almost certainly happen.
Crucially, they need a much firmer oil price to have any chance of floating a 5 per cent share of state oil company Saudi Aramco for a very ambitious US$100 billion.
The country is to release secret details about the true extent of its reserves, frozen at a constant 260 billion barrels since the inception of the modern oil age – a patently absurd estimate.
“We think the Saudis want to see prices at $60,” said Amrita Sen from Energy Aspects. “There is so much hardship in the Kingdom and they know what the repercussions are if there is no deal: prices are going to fall very sharply.”
Ultimately they want to keep the price in a “sweet spot” between US$60 and $80, preventing it rising so high that it leads to a fresh surge of investment in renewables – the real enemy.
The paradox of oil today is that although the market is over-supplied, spare capacity has fallen to wafer-thin levels as OPEC states produce flat out, and the Saudis have just 1.5m b/d left as a safety buffer. All it will take is a geostrategic shock or disruption somewhere in the world for the market to tighten viciously, leading to a fresh global crunch.
Sen said China’s output has fallen by 450,000 b/d, Mexico is down 200,000 b/d, and deeper-water investment has collapsed everywhere. “The risk is that prices are going to react in about 18 months. I wouldn’t rule out a spike to US$100,” she said.
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