Don't expect every nation to comply with the next round of OPEC production cuts

Picture: Getty Images

The consensus view in markets is that OPEC will agree to extend production cuts at tonight’s meeting in Vienna.

Barclays analysts Michael Cohen and Warren Russell agree that “OPEC appears set to extend its production cut agreement for an additional nine months”.

However, they noted that the next round of cuts was unlikely to get full compliance from OPEC member states.

They also said that OPEC needs to clearly articulate an exit strategy to the market to avoid distortions when the next agreement expires.

Cohen and Russell said that if the deal was agreed to, their price prediction for benchmark crude oil in the second half of 2017 was $US56. In the unlikely scenario that a deal isn’t struck, crude prices would fall to around $US45.

While a supply-cut extension to March 2018 is widely expected in the market, Cohen and Russell said that full compliance from OPEC members is unlikely once the extension is approved. That means that OPEC member countries are likely to pump more oil than their agreed restricted quota.

Cohen and Russell calculated that the supply cuts have boosted revenues to member states by around 11%. However, the current price of oil is still below the fiscal break-even point for most OPEC countries:

The two analysts said that while compliance with the first agreement had been close to 100%, OPEC’s stated goal to reduce global stock levels hadn’t been achieved.

While noting that “the absence of a global benchmark petroleum stock series makes it difficult to get a sense of the reality on the ground”, Cohen and Russell said that the stock build-up was due to two main factors.

They cited “the inherent lag between cuts and production and actual supply”, as well as a build up of oil stocks in China.

“In our view, stocks in China are inflated because Chinese independent refiners have ramped up imports to take advantage of increased quotas and because of the government’s ongoing strategic stockpiling program,” they said.

Outside of China, the two analysts said that there had been a notable reduction in supply since the second half of 2016.

Of course, the other key factor contributing to supply is the growth in the US shale oil industry which continues to beat market expectations.

The number of US oil rigs keeps climbing, and with a more efficient cost base Cohen and Russell said that US drilling companies should remain profitable unless West Texas Intermediate (WTI) crude falls consistently below $US50 a barrel.

For the next round of OPEC cuts, Cohen and Russell said that specific quota levels and the number of countries participating hasn’t yet been finalised. They said that investors should expect some changes from the November 2016 agreement which expires in June.

Source: OPEC

Once the new agreement was agreed to, Cohen and Russell highlighted the importance of articulating a clear exit strategy to the market.

“Now that OPEC is headed down this path, it must figure out a way to gradually step away from deliberate supply management when it believes the fundamentals merit their incremental oil,” they said.”

“If OPEC does not manage the message clearly when and at what pace its oil will return, it risks sustained oil price weakness as market participants price in a surge in eventual OPEC output when the deal ends.”

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