Saudi Arabia could be having a change of heart on oil

Reuters/Ali Jarekji

Deliberately worded, and perfectly timed, comments from world oil producers regarding oil production seem to make airwaves on a daily basis. Each time oil falls below $30 a barrel, a bullishly worded statement with no evidence of meaningful change or impact, is uttered from a producing nation. Without fail, the news causes weak shorts to cover and an aggressive rally ensues.

However, fatigue seems to be setting in… initial excitement around Tuesday’s joint announcement between Saudi Arabia, Russia, Qatar and Venezuela about freeze production to January output numbers quickly fizzled, and the market ended down on the day. Venezuela should at least be commended for its efforts to rally the troops.

On the surface, “freezing production” sounds bullish, but once analyzed is bearish… neutral at best. If these four countries, which make up 25% of world oil supply, do indeed freeze at current levels, there is no net change to the 2016 supply forecast (highlighted in Table 1). Furthermore, even if all OPEC nations + Russia decided to freeze at January levels, it would translate to an increase of 340kb/d of incremental supply, as Nigeria, Iraq and Russia have dramatically ramped up production in the last three months. Lastly, chances of Iran abiding are slim as they have vocally reiterated their plans to increase production to pre-sanction levels. So in a nut shell, these four nations are agreeing to freeze output at all-time highs, keeping OPEC 2.3 million barrels a day over quota – quite a departure from OPEC’s old comments of “adhering to quota.”

What is notable is Saudi Oil Minister Ali Al-Naimi’s comment “beginning of a process” that could require “other steps to stabilize and improve the market.” This is the first time in this recent war of words that we have heard statements from Al-Naimi; statements that seem to indicate a subtle change in policy. Saudi Arabia’s policy of defending market share, rather than cutting output is working. Remember, OPEC is not the reason we initially became oversupplied. OPEC production was declining prior to the mid 2014 price collapse; balances were tipped by Non-OPEC production.

So why change policy now when it is finally working? Even the most resilient marginal producers (Shale or Deep Water) have given up hope and finally begun capex cuts, which should lead to production declines. However, we will not see material declines until the second half of this year. A cut in OPEC production now, without seeing those capex cuts materialize will only give the marginal players time to scrap cuts, and sustain production. Saudi needs to see this policy through; wavering now would be a labour in vain and a possible signal of defeat. So how can they overcome?

The US Energy Information Administration (EIA) and International Energy Agency’s (IEA) most recent report show that the world’s over supply of oil is much worse than previously forecast: a fourth quarter increase of 2.2 mmb/d up 620kb/d from the third quarter. The sharp increase in oversupply was not due to a supply surprise, but a demand revision. The trend has continued as each month this year both the EIA and IEA have revised down their forecast for 2016 by about 250kb/d. Demand, which arguably kept a floor on oil in 2015, seems to be slowly eroding. Perhaps this is why Saudi Arabia is having a change of heart?

The cartel revised down its numbers for 2015 world economic growth in its January 2016 OPEC Monthly Oil Market Report, and cautioned “the growth risk is skewed to the downside as both emerging and some OECD economies are facing several challenges.”  Saudi Arabia has always been concerned about demand; they have predicated their new policy on the premise of strong demand. If indeed there are cracks in demand, then perhaps this would give them an opportunity to ease their stance.

Though this freeze does little to supply balances, an agreement to freeze is a softening of Saudi policy, and could indicate a change of heart. I believe Saudi is watching demand very closely. Given the revisions in demand, massive supply glut, increased turmoil within the cartel, and softening of Saudi’s stance, I believe the possibility of a supply cut during OPEC’s June meeting is now on the table.

Reuters/Ali Jarekji

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