In May 2017, OPEC extended its production cuts as it continues to target a reduction in oil inventories to support prices. However, despite some encouraging signs, global stocks remain elevated which in turn has caused investors to question OPEC and Russia’s commitment to cuts amid fears they may flood the market again. Given our positive view on energy stocks and certain oil producing currencies, this is a key risk for us.
The call on OPEC is defined as the amount of oil required from them to balance global oil supply and demand. Analysing oil supply and demand through to 2020 allows us to understand how much oil non-OPEC countries will produce and in turn the revenue impacts of different reactions from OPEC. We believe OPEC will reach similar conclusions and continue to limit production throughout the period, in turn supporting prices.
Before prices halved in 2014, average annual oil demand for the previous decade had been 1.1% p.a.. Since then, it has risen to 1.8% and we expect it to fall back towards 1.4% going forward as the initial impetus from lower prices fades.
Non-OPEC, non-shale (NONS) is determined by current supply, the rate of existing oil fields’ production declines and new projects. Given the lead time on new projects and the available data on decline rates, then we have a good idea of future production, assuming no unexpected disruptions. New projects already sanctioned in areas including Kazakhstan, Brazil, Russia, Mexico, Canada and the North Sea suggest new supply of c.1.5mbd annually to 2020. Coupled with a decline rate on existing, post-peak production of about 5% per annum, that suggests the call on OPEC and US shale is about 1.5mbd.
US shale production is very price sensitive and can increase and decrease rapidly when necessary. Shale has confounded critics, with oil production (including both crude and other liquids) likely to rise c.1.5mbd in Q4 2017 compared with just a year earlier, due to a combination of increasing rig counts and productivity per rig.
US production growth should slow given WTI oil prices have trended down since March this year. However, we still expect future productivity gains to outstrip cost inflation and so production will continue to rise. As a result, even at prices between $45 and $55, we expect almost 1mbd of annual production growth from US shale until 2020.
So that leaves the call on OPEC rising at just 0.5mbd annually, with much of that back-ended to 2019-2020. That leaves its members with a conundrum; should they allow US shale and NONS to dominate production growth to 2020, with 2.5mbd between them, or match them in increasing production?
It’s a trade-off for OPEC between volume and price. Knowing that US shale will react rapidly to a given price and that NONS growth is determined years in advance, then OPEC is left as a large, coordinated block of supply that can choose to limit supply and increase prices. One limit on how they can push prices though is that if they push prices up too high in the longer term, it will encourage more production elsewhere.
Given that demand is relatively insensitive to price, we see significant benefits to limiting production and supporting prices. For example, we estimate that in a naturally over-supplied market as we see currently, incrementally limiting supply by 0.6mbd on a sustained basis could increase prices by as much as $5; so over a 10% price increase for just a 2% production cut.
With such a strong incentive, it’s clear why OPEC, in conjunction with Russia, cut production in November last year and have now extended it. Based on our global supply and demand forecasts, we believe that to maintain a price range of $45-$55, OPEC and Russia will need to maintain production constraints to 2020 unless there are new supply disruptions.
The biggest risk to production cuts being maintained, other than future recession and dramatic fall in demand, is the sense of injustice for OPEC members and Russia that all producers benefit from higher prices, but only some are harmed by production cuts. Ideally they would like to see more production constraint elsewhere, and may be periodically inclined to depress prices to cause pain to other producers and to scare them off committing to too much investment. But then OPEC will want to return to the higher revenues that come from higher prices.
It’s a delicate balance, of course, as the rise of US shale has taught OPEC. By keeping prices too high after the global financial crisis they encouraged high levels of investment which ultimately led to huge technological advances and rapidly falling production costs. OPEC will be mindful that if prices move above $50-$55 then shale, and potentially other producers, may rapidly ramp up spending. As such we see a price bound between $45-$55 as a target for OPEC, with inevitably higher prices if there is a significant new production disruption and lower prices in the case of a significant regional or global recession.