Does an OPEC agreement matter?

By D. Mason Granger | November 25, 2016 | Last updated on November 25, 2016
5 min read

The September move by OPEC toward a tentative deal in Algiers confounded most oil market watchers. Then again, the move by Saudi Arabia two years ago in November 2014 also caught us by surprise.

The Kingdom appeared to eschew production cuts, in its traditional role as the swing producer, in favour of a costly, two-year battle for market share. This battle has seen Saudi Arabia erode its savings by hundreds of billions of dollars to wring out the marginal shale oil barrels and inflict pain on its regional rivals. Now, in the seventh inning of this costly battle for market share, Saudi Arabia and its OPEC cartel members, as well as key producer Russia, appear to want a truce to end the bleeding.

Two years into this rout in oil prices, we ask: Does an OPEC deal really matter? The tentative deal reached in September had largely put a floor into oil prices—in the low-US$40s per barrel as of November 14—until the November 30 meeting. In the worst-case scenario, the tentative deal falls through, and the global market is two months closer to an eventual balancing point of global supply and demand following the September announcement.

This is the point at which inventories begin to fall toward more normal levels, and there are already tentative signs that global inventories may have already crested. It is also an inflection point that should bring into focus two years of chronic underinvestment in new supply. In the best-case scenario, any semblance of producer discipline should lift prices to levels allowing for substantial free cash flow generation of a new, leaner and meaner generation of North American producers (see “Oil: $60 is the new $90AER September).

The good news is that the prospect of an OPEC deal seems to have put a floor under prices and significantly reduced speculative short positions in crude oil futures. As the market seemingly places higher bets on a deal that most market watchers, until recently, would have characterized as highly improbable, we believe that fewer investors will want to place short bets ahead of key meetings.

Not a demand shock, a supply shock

The majority of OPEC reactions in the last three decades have addressed demand shocks, not supply shocks. The only period that significantly resembles the current situation is the mid-1980s price crash. The main similarity to the recent experience is that overinvestment in new supplies in non-OPEC countries had eroded market share. In the period between the global credit crisis and the oil price crash, ultra-low interest rate policies created unfettered access to capital markets, particularly for North American producers. Easy access to debt capital and persistently high, stable oil prices allowed for substantial production growth against a backdrop of game-changing technological revolution.

Pundits seem to suggest that even a modest rebound in global prices now will bring a surge in unconventional shale oil production. As of early November, the U.S. oil directed rig count was down 72% from its October 2014 peak, and was still well below the activity level generally seen as necessary to sustain U.S. oil production, particularly given declines in unconventional shale production. We believe the U.S. industry is not likely to significantly increase its capital expenditures until crude oil prices are sustainably US$55 to US$60 per barrel. There seems to be collective hand-wringing over an apparent paradox that modestly higher oil prices will trigger an onslaught of new U.S. supply, effectively capping any further price increases. We disagree in many respects.

Even when oil was at US$100, the majority of non-OPEC countries struggled to maintain or even grow production. Shale oil, in a world of much lower oil prices, cannot change this predicament. UBS recently estimated that, across its global coverage of 79 major oil companies, upstream capital expenditures were down 44% over 2014 to 2016. Further, new major project sanctions last year and this year are running at about 20% of what they had in previous years. Chart 1 shows the global collapse in spending.

These major projects typically take four years to come to market. It’s not a matter of weeks, as it is for short-time-cycle shale wells. In essence, underinvestment has created a two-year hole for new supply in the coming years that is estimated to be approximately four million barrels per day. It is highly improbable that shale oil could compensate for this.

Sailing too close to the rocks

Much ado has been made of the similarities between the now and what happened in the mid-1980s, when Saudi Arabia supposedly waged a market-share war that effectively crimped non-OPEC supply growth.

But the key difference is that there were 16 million barrels per day of OPEC spare capacity in 1983. Today, there are virtually none. The global oil business can be viewed as running flat out, with little capacity to make up for additional losses in production.

The market seems particularly fixated on the gyrations of monthly production figures from countries like Nigeria and Libya, or strong production figures from Iraq, and the aspirations of Iran. It is also worth noting that president-elect Donald Trump on the campaign trail had mused about reopening the Iran nuclear deal, however unlikely this ultimately may prove. With Saudi Arabia producing at approximately 10.6 million barrels per day, the question is whether it actually has another two million in spare capacity. Many close to the Kingdom’s oil industry would say no. Regardless, as Chart 2 shows, spare capacity is exceptionally low in a world of underinvestment in new supply. This is a very different scenario than the mid-1980s.

An OPEC deal this month: How much would it matter?

The 1985 to 1988 period was characterized by uncertainty around OPEC meetings and “non-meetings” between OPEC and non-OPEC members, similar to Algiers in September. We are cautious because a few of these mid-1980s meetings ended with production agreements that lacked a formalized deal. There was even a formalized OPEC agreement in December 1986 that quickly unraveled the following year, during the implementation phase.

OPEC’s compliance is often short-lived and the pressure to cheat on quotas is intense. Some of OPEC’s members attempted to cut production in 1987, but quickly increased it as the recovery lost momentum. In this case, any such deal relies on its key member, Saudi Arabia, to cut production while potentially allowing Nigeria, Iraq and Libya the flexibility to increase production according to their circumstances. A tenuous deal also relies to a certain extent on Russia making good on the Algiers agreement. But Russia has a longstanding tendency to say one thing and do the opposite. As Chart 3 shows above, OPEC’s compliance with its own agreements has been historically poor. However, should this deal be our focus?

In a world of razor-thin spare capacity and chronic underinvestment in future supply, we argue more that this is a sideshow to larger industry issues.

Positioning for supply-demand

General sentiment suggests that investors are increasingly constructive on energy in 2016. The worst is behind us and a balanced market should be achieved in the coming quarters. We believe the market and futures underestimate supply-demand tightness in the coming years. Coming out of the energy price crash, the Canadian oil and gas sector has reinvented itself with a leaner, more competitive cost structure. Investors should focus on stronger companies with access to capital and sustainable cost structures as we emerge from this downturn.

by D. Mason Granger, P.Eng., MBA, CFA, is a portfolio manager in Toronto.

D. Mason Granger