The Fuse

OPEC+ Nears Extension, But Task Doesn’t Get Any Easier In Months Ahead

by Nick Cunningham | June 03, 2020

Russia and Saudi Arabia appear ready to agree to extend the OPEC+ production cuts for another month or two, at least according to recent trade press reports. An extension led to an upswing in oil prices on expectations that the market would continue to tighten.

While up from negative territory, oil prices are at far from desirable levels.

With both supply and demand still sharply down from pre-pandemic levels, oil producers are still feeling the pain. While up from negative territory, oil prices are at far from desirable levels. An extension at least prevents another downturn. However, a deal is not done yet, and the upcoming meeting may once again carry tension and drama.

OPEC+ ready for extension?
As negotiations continue behind the scenes, Saudi Arabia has pushed for an extension through the end of the year. Russia, instead, has favored loosening the production cuts beginning at the end of this month, but may settle for a short-term extension.

The 9.7 million barrel-per-day (Mbd) cut that took effect in April was the largest reduction in history, and helped to rapidly move supply closer to much-reduced demand levels. Oil prices bottomed out at -$37 per barrel in April, with Brent rising back to $40 just at the start of June. News that an extension was near helped add to positive momentum.

But as scheduled meeting approaches, familiar divisions have resurfaced. Saudi Arabia and Russia have issued demands to other producers, making an extension contingent upon much better compliance with the cuts. Several producing countries have lagged in their compliance, with Iraq and Nigeria standing out. For instance, Iraq was supposed to cut around 940,000 bpd, but only cut about a third of that, according to Standard Chartered.

Without an extension, the existing arrangement phases down the cuts from 9.7 Mbd currently to 7.7 Mbd beginning on July 1. As of June 3, it appears that agreement a one-month extension is within reach, according to S&P Global Platts, with strict demands that all producers up their compliance and even make up for overproducing in recent months by cutting deeper.

An extension would solidify the move towards some sort of balance, but the overall market is still vastly smaller.

OPEC+’s task doesn’t get easier
An extension would solidify the move towards some sort of balance, but the overall market is still vastly smaller. The IEA estimates that demand will average 91.2 Mbd in 2020, down from 100 Mbd prior to the pandemic. OPEC+ is keeping 9.7 Mbd offline in the near-term, and the U.S. has lost close to 2 Mbd as well. In other words, the market has “balanced,” and may even continue to “tighten,” but the convergence of supply and demand is happening at sharply lower levels.

The OPEC+ coalition faces multiple challenges, beyond the immediate hurdle of coming to a short-term agreement.

First, the extension is very short and it’s unclear what the group will do in a month’s time. A follow-on problem from that is maintaining group cohesion for any lengthy period of time is difficult. Russia has already shown reluctance towards an extension. By any reasonable assessment, OPEC+ cannot simply unwind its cuts to pre-pandemic levels without crashing the market. That will also be true in July or August when OPEC+ members will likely even be more antsy to loosen restraint.

Looking out further, will all countries involved stay together through the duration of the agreement, which lasts in some form through the middle of 2022? Russia itself routinely overproduced in the past, despite its elevated role in negotiations.

“We also still have significant doubts about the strength of Russia’s resolve to see the process through to the end,” Standard Chartered wrote in a report published on June 2. “We think strong forces remain within Russia that wish to detach it from output restraint as soon as is expedient.” Meanwhile, Saudi Arabia looks set to unwind some of the “extra” production cuts that it put into place for May, according to the FT. That could result in an additional 1 Mbd beginning in July, even if an extension goes forward.

A larger problem is the massive oil inventory overhang. If OPEC+ does not extend and instead sticks with the current arrangement – which, to be clear, tapers down rather than expires altogether – inventory “normalization” would last until March 2022, according to the analysis from Standard Chartered.

“With the taper in place, the monthly stock draws in H2-2020 are relatively modest,” the bank said, only normalizing inventories by 20 percent. Analysts added that a one-month extension would be “rather weak,” and instead said a six-month extension – on the lines of what Saudi Arabia apparently prefers – “sends a message of intent.” Extending through the end of the year would take care of 60 percent of the overhang. But that avenue does not appear to be on the table.Finally, the fate of U.S. shale is up in the air. Already a few shale drillers have signaled their intent to return to drilling. “The more cautious countries might be bearing in mind the fact that sticking to the current cuts for too long would benefit US shale oil producers,” Commerzbank wrote in a note on Wednesday. “Back in 2017, the OPEC+ policy of cutting production also paved the way for a comeback of shale oil production. OPEC+ should keep this in mind before deciding to extend its production cuts for too long a period.”

It will take years for the industry to grow back to its former size, if it ever can.

In the past, this problem presented a larger conundrum for OPEC+. Any boost in prices sparked an immediate reaction. This time around, the meltdown in the market will likely present some permanent (or at least medium-term) damage to shale drillers from which it will be difficult to recover. The rig count is at record lows, the industry won’t be recapitalized in the same way that it was in past downturns and a wall of debt looms. It will take years for the industry to grow back to its former size, if it ever can.

Against that backdrop, OPEC+ may not have to worry quite as much. Steep decline rates will take hold in U.S. shale, likely overwhelming any uptick in drilling for the rest of the year. Standard Chartered says production may not resume a growth trajectory until late 2021.

Nevertheless, with demand far from pre-pandemic levels, OPEC+ will likely need to carry on with substantial cuts for the foreseeable future.