OPEC meeting ends in disagreement, but market rebalancing still on track

June 2016 | Anders Norlen, Evelina Pagkalou

Representatives from OPEC gathered for the organization’s first planned meeting of the year Thursday, with the notable exception of Saudi ex-oil minister, Ali Al Naimi. Khalid A. Al-Falih now represented the Saudi Kingdom as its new oil minister, promising to remain on the same course as his predecessor.

This time around, the expectations were also different: there was barely anyone expecting action regarding an output freeze would take place, in contrast to the uncertainty that surrounded the emergency meeting in Doha in April. As anticipated, the meeting ended with a decision to stay firm to the current strategy and take no further actions towards directly intervening in the market.

With oil prices back to the high forties and signs that oil supply and demand are closer to rebalancing partially thanks to recent supply disruptions, it appears the OPEC decision to let the market rebalance itself is beginning to have effect. Yet the longer OPEC stays on its current route, the more two different blocs emerge among its members, centred on their hopes for a production ceiling:

1. There are continued calls to cut production from cash-strapped members – led by Venezuela and Nigeria – who are still struggling with current account deficits and balance of payment problems. The lack of oil revenues has led to the countries’ output to fall, as their economic struggles start to reflect on their capacity to operate their oil infrastructure. This bloc of countries would like to see a coordinated effort among the organization to reduce supply, to further support prices.

2. On the other side are the more financially stable members – led by Saudi Arabia and its Gulf allies - whose prime target is to protect their market share. They are currently producing at all-time high levels and can sustain themselves even if price falls again below USD 50/bbl. Iran is now restarting exports and trying to boost output to pre-sanctions levels so it naturally falls under this bloc.

Given the diverse opinions on any coordinated action, the organization’s continued unity will have to depend on the speed of rebalancing of global supply and demand outside OPEC. Most analysts, including Energy Insights, see the market rebalancing on a fundamental level by 4Q 2016/1Q 2017, but high inventories might bring prolonged pain to strained producer countries by delaying the price recovery.

OPEC’s cohesion is dependent on the financial strength of its members... and Saudi

The last six months have not been easy on the financially weaker members of OPEC. The price collapse has resulted in widening budget deficits, which have in turn resulted in political challenges and production disruptions. The recent price rally helped take the worst of the pressure off, with their current account deficits now narrowing.

Yet despite being relieved from the price lows of February, the oil price needed by most OPEC members to balance their fiscal budgets (fiscal breakeven) is still above USD 90/bbl. As a result, OPEC is now running in two different speeds, depending on the ability of each member to sustain production in unfavourable price conditions.

We have witnessed falling production for Algeria, Nigeria and Venezuela (-10%, -17% and -6% over last 24 months), with the last two facing increasing difficulties in sustaining their oil output. The failure to reach an agreement for a production freeze in the Doha discussions was not received well from the governments of these countries, for which any increase in oil price would make a considerable difference in their ability to fund oil operations and their government. Iraq has also been financially struggling, although a recently approved USD 4.5 billion loan from the IMF should provide some short-term relief to the Iraqi government.

In contrast, oil production in financially healthy Saudi Arabia, Kuwait, UAE has never been higher. They can afford it; not only is their fiscal breakeven much lower, but they are also in possession of considerable sovereign wealth funds. These members – driven by Saudi Arabia – are unlikely to change course and plan to continue to keep output at record level to preserve market share. Saudi Arabia demonstrated it was not ready to remove any volume from the market in a coordinated “production freeze” due to worries about loss of market share to other major exporters and US onshore producers.

Exhibit 1

Meeting in the middle when it comes to a production freeze has become further complicated by the return to the market of Iran. Iran has ramped up production by 0.67 Mbd from the lifting of the sanctions in January, and is on track to deliver on its promise to raise production by 1 Mbd “within 12 months” as laid out by oil minister Zangeneh in December. In the midst of a power struggle for market share between the rising Iranian output and Saudi oil, concerns about the financially weaker members of OPEC seem to have been put on the side, damaging the ability of OPEC to act in coordination and potentially freeze production.

Market on course to rebalance thanks to declining non-OPEC supply and strong demand might temporarily solve the organizations’ inner struggles

Given the constraints inside OPEC in achieving coordinated action, the increase in oil prices will most probably come from a rebalancing of non-OPEC supply and demand. The underlying growth in demand for 2016 is expected to reach 1-1.2 Mbd, and non-OPEC production is expected to decline by 1.1-1.2 Mbd. Energy Insights expects the market to balance on a fundamental level in early 2017. Forecasts by both OPEC and IEA support this picture, with the timing in the rebalancing varying by a few months.

The main supply side risk is unplanned outages of productive capacity, which for the first half of 2016 has stood at an average 3.5 Mbd, including 2.5 Mbd long-term disruptions from Libya, the Neutral Zone, Sudan and Syria. The additional 1 Mbd has been driven by the Canadian wildfires, Nigerian sabotage, turnarounds in the UAE and political issues around KRG exports through Turkey. Should substantial amounts of these supplies come back online soon, the rebalancing will see a corresponding push out in time.

If this rebalancing leads to a higher price, then the need for OPEC to act as a bloc will be less urgent. However, a substantial inventory overhang raises doubts about how high prices can go in the next two years; it is very unlikely that price will cross the USD 90/bbl threshold needed to balance most of OPEC national budgets. It remains to be seen whether the OPEC members will continue to be looked upon as a bloc by coordinating actions to raise the price further, or whether we will need to start thinking about an OPEC of two speeds.

Exhibit 2


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About the authors

Anders Norlen and Evelina Pagkalou are both senior analysts with Energy Insights in McKinsey's London office.

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