Opinion

OPEC Production Cuts and The Long Road To Market Balance


Global oil inventories are falling because of OPEC and non-OPEC production cuts but the road to market balance will be long.

Production cuts have removed approximately 1.8 million barrels per day (mmb/d) of liquids from the world market since November 2016 (Figure 1).

Figure 1. OPEC-NOPEC Have Cut 1.8 mmb/d Liquids Since November 2016. Source: EIA April 2017 STEO, EIA International Data and Labyrinth Consulting Services, Inc.

Saudi Arabia has cut 619 kb/d (35% of total) and the Gulf States Cooperation Council—including Saudi Arabia—has cut 1,159 kb/d (65% of the total). Other significant contributors outside the GCC include Iraq (12%), Russia (12%) and Mexico (9%) (Table 1). Nigeria's cuts are probably involuntary since it was exempted from the OPEC agreement. Iran and Libya–also exempted–and both increased production.

Table 1. Summary table of OPEC-Non OPEC production cuts, November 2016 through March 2017. Source: EIA April 2017 STEO, EIA International Data and Labyrinth Consulting Services, Inc.

Inventories and The Forward Curve

OECD inventories began falling in July 2016, four months before the OPEC production cuts were finalized. Stock levels have declined approximately 107 mmb according to recently revised EIA STEO data (Figure 2). That includes the January 2017 increase recently noted in the April IEA Oil Market Report .

Figure 2. OECD inventories have fallen more than 100 million barrels since July 2016. Source: EIA April 2017 STEO and Labyrinth Consulting Services, Inc.

Although this represents progress toward market balance, stocks must fall at least another 260 mmb to reach the 5-year average level to support oil prices in the $70 per barrel range.

Almost three-quarters (73%) of OECD decline was from non-U.S. inventories. Perhaps the intent of OPEC's November cuts was to stimulate a decrease in U.S. inventories (about 45% of the OECD total). U.S. stocks and comparative inventories were increasing at the time of the cuts and did not start to fall until February 2017 (Figure 3). Since mid-February, U.S. stocks and comparative inventory have each declined 20%.

Figure 3. U.S. Comparative Inventories Have Fallen 20% Since Mid-February 2017. Source: EIA and Labyrinth Consulting Services, Inc.

Still, U.S. inventories must fall another ~150 mmb to reach the 5-year average (Figure 4).

Figure 4. U.S. Crude Inventories Must Fall ~150 Million Barrels to Reach the 5-Year Average and Higher Oil Prices. Source: EIA and Labyrinth Consulting Services, Inc.

The immediate results of the OPEC cuts were an increase in oil prices and an important change in the term structure of crude oil futures contracts. Before the cuts were announced, the term structure of the WTI oil futures curve was in contango (prices are higher in the near-future). That favored storing rather than selling oil and contributed to growing inventory levels (Figure 5).

Figure 5. The Term Structure of WTI Futures Contracts Changed From Contango To Backwardation After the OPEC Production Cut in Late November 2016. Source: CME and Labyrinth Consulting Services, Inc.

In early March 2017, however, oil prices fell as investors lost confidence that the cuts were working. Forward curves moved into weak backwardation (prices are lower in the near-future). Now, prices have increased with outages in Canada and Libya, and the forward curve has moved into stronger backwardation. That favors selling rather than storing crude oil and contributes to decreasing inventory levels.

Market Balance, Supply and Demand

The latest IEA Oil Market Report stated, “It can be argued confidently that the market is already very close to balance.” What does that mean?

Market balance means that production and consumption are approximately equal. That is an important first step for a market in which production has exceeded consumption for most of the last 3 years but it hardly means that $70 oil prices are around the corner.

Market balance must be expanded to be useful: production is not the same as supply, and consumption is not the same as demand. Supply is production plus inventory. Demand is the quantity of oil the market is willing to buy at a certain price–it may be either more or less than production.

Oil prices collapsed in 2014 because demand wasn't great enough at $100 per barrel to absorb the output from the 2010-2014 production bubble. Prices collapsed to $30 per barrel before a transformed market began a weak and uneven recovery, and production surpluses began to decrease slowly (Figure 6).

Figure 6. Critical Supply & Demand Are In Approximate Balance. Source: EIA April 2017 STEO, IEA OMR, OPEC MOMR and Labyrinth Consulting Services, Inc.

Demand did not increase enough until July 2016 to require critical supply withdrawals from inventory–a small subset of total supply. U.S. inventories did not begin to decline until after the OPEC cuts took effect in February 2017.

In the real world, the 5-year average inventory level represents a dynamic proxy for market balance. Comparative inventory is the measure of how far the present market must rise or fall to reach that level. IEA data indicates that inventories are 330 mmb above the 5-year average although revised EIA data suggests that levels are closer to 260 mmb higher than that important benchmark. In either case, it will take 6 months to a year to approach the 5-year average.



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