Oil outlook to 2019: OPEC's role

October 2016 | Evelina Pagkalou

OPEC accounts for over 40% of global crude and other liquids production. In the last two years, it has also accounted for 70% of global liquids growth which has helped keep the oil market oversupplied, and has put a lid on prices. The most recent deal by its ministers to constrain production could be pivotal in rebalancing of the global oil market, but the details are yet to be clarified leading to the official November OPEC conference. OPEC’s course of action in the next 12 months will define whether the industry will experience a slow and smooth recovery to a sustainable price equilibrium, or a period of underinvestment leading to a volatile and high oil price. Even if the recent provisional deal produces minimal results, OPEC Gulf countries will ultimately need to cut production if operators expect prices to recover in the next three years.

Exhibit 1: Significant shifts in supply and demand led to an oversupplied market with OPEC adding 2.5 million b/d to its production in the last 2 years

SOURCE: EIA, Energy Insights

Back in 2014, the oil price collapse alerted the oil industry and the world to the fact that the global oil market was structurally oversupplied. Non-OPEC production, especially light tight oil in the US, was the main driver of growth before eventually slowing down and reversing to decline as operators adjusted to a $40+/bbl world. In contrast, OPEC countries added 2.5 million barrels of oil since June 2014, preferring to promote their low-cost resource in a market share competition instead of ceding market share to protect prices. Price has suffered as a result, and the oversupply has persisted much longer than expected.

Two weeks ago, the OPEC ministers met in Algiers and agreed on a provisional deal to limit their collective output to 32.5-33 million b/d from the 33.24 MMb/d the organization had produced in August. While the production reduction of 250-750 Kb/d does not seem significant, it has provided a clear sign that the OPEC producers, and in particular its Gulf members of Saudi Arabia, Iran, Iraq, and UAE, think it is time to act.

The effectiveness of the implementation deal is not assured. On one hand, the deal is still provisional, and subject to the deliberations that will happen in the official OPEC Conference in November. It is still not clear who will cut production, given that both Iran and Iraq have expressed their reservations against limiting their growing production. Finally, the levels of the cuts themselves are disputed: the 33.24 MMb/d produced by the organization in August that is used as a base for the decrease incorporated peak summer production for Saudi Arabia.

On the other hand, ahead of these talks there was very little hope any agreement would be reached due to internal political conflicts, so this agreement showcases the determination of the OPEC members to act, and act as a unit. Additionally, president Putin declared Russia’s willingness to cooperate to a production freeze/cut, which increases the potential for an effective production reduction.

The direction this deal will evolve at and the subsequent policy decisions by the OPEC members will define the path to oil price recovery by the end of the decade. Energy Insights believes the most possible scenario is a slow recovery case, which incorporates action from the OPEC members such as the provisional deal to be implemented. In such a scenario, supply and demand slowly balance during this time period, and prices start their road to recovery to reach USD60-70/bbl by 2019. OPEC would eventually maintain a stable market share of around 45-46% of global crude & condensate production as the oil price slowly recovers.

Exhibit 2: In the Slow Recovery scenario, OPEC Gulf (1) members restrain their production by 2019 to accommodate budget considerations

SOURCE: Energy Insights

If OPEC does not cut this time and future deal negotiations also fall through, there is a considerable chance that the market will continue being volatile in the coming years, as market corrections will last longer and be more pronounced without OPEC action. Already the delays and cancelations of non-OPEC projects are curtailing the supply stack, and without a higher oil price this market can quickly shift to undersupply once excess inventories are released. In a scenario where OPEC production stays flat or keeps increasing by 2019, the global oil market will still eventually rebalance, but it is very doubtful the price will recover fast enough to keep non-OPEC marginal production of USD50-60/bbl in the market and avoid a period of steep undersupply. For OPEC itself, such an underinvestment world would mean that national budgets would need to factor in prices below $50/bbl for yet some time, before prices shoot up while rebalancing.

Both worlds are possible; there is no assurance that current negotiations between OPEC members, especially Gulf countries, will be successful. The internal politics are divisive, and the market share protection policy makes the most sense for the Gulf producers given their extremely competitive oil reserves. Yet it is widely acknowledged that current prices are wreaking havoc in their balance sheets. There is no clear visibility on how long individual OPEC operators can withstand low oil price. As observed, even producer countries that have resisted taking action have now come to the table to discuss, which indicates that prolonged low oil prices has become a scenario no operator wishes to witness any more.


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About the authors

Evelina Pagkalou is a senior analyst with Energy Insights in McKinsey's London office.

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