OPEC faces numerous dilemmas this week as it meets to decide what, if anything, is to be done about falling oil prices. As Goldman notes, consensus expectations have shifted to only expecting a modest cut announcement on Nov 27th. Furthermore, any large cut that would lead to a large price rally would be self-negating as it would enable US producers to hedge 2015 production and sustain elevated production growth.
Via Goldman Sachs,
We expect at most a modest cut
We expect OPEC to announce at most a modest reduction to current production on November 27. As we have discussed, we believe it is in OPEC’s interest to share the burden of balancing the oil market surplus with US shale oil production (and Price decline continues to lead deteriorating fundamentals). This can only be achieved by reducing output at a modest pace at first to allow for low prices to slow US production growth. In particular, any large cut that would lead to a large price rally would be self-negating as it would enable US producers to hedge 2015 production and sustain elevated production growth. Recent communication by OPEC members suggests indeed the expectation of only a modest reduction in production, with Libya, Iraq and Iran further commenting that they would not be reducing output (Exhibit 4).
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These divergences lower the odds of a coordinated cut, and past quotas have only been loosely implemented (Exhibit 5).
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Large cut would support prices but be self-negating in 2015
We believe that consensus expectations have also shifted to only expecting a modest cut. While the large decline in prices and short market positioning leaves risk to prices skewed to the upside on a larger cut, prices have rallied recently with the Brent option market starting to reflect call option buying interest as well since prices broke below $85/bbl (Exhibit 1).
Brent front month timespreads have also rallied by $0.22/bbl this week, which our modeling suggests would be equivalent to a 250 kb/d reduction in the global market surplus over the coming months. As a result, we estimate that it would require a cut in production of more than 0.5 mb/d to below the current quota for prices to rally significantly next week, with the current Brent implied volatility term structure already implying a $3.6/bbl move on November 27 (Exhibit 2). Specifically, we estimate that a 1.0 mb/d production cut to 29.5 mb/d could push Brent prices back between $85/bbl and $90/bbl (Exhibit 3).
The OPEC Dilemma
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However, uncertainty about the implementation of this new quota and the likely large hedging flows following an initial rally would ultimately cap the price rally and leave our fundamental 2015 balance little changed as higher US production growth would offset lower OPEC output, leaving the oil market oversupplied. While media reports suggest that the odds of a lift of Iran sanctions by November 24 have declined, an extension of the deadline and ultimate agreement remains an upside risk to our 2015 production forecast and inventory build.
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Finally, don't forget the reason for this...
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