The Math Behind OPEC's Revised Production Cut Still Does Not Work

"Whatever it takes."

Saudi Energy Minister Khalid al-Falih and Russia's Energy Minister Alexander Novak

That's what Saudi Energy Minister Khalid al-Falih and his Russian counterpart Alexander Novak said in a statement overnight in Beijing they would do to reduce the global oil inventory overhang, using the immortal phrase coined by ECB's Mario Draghi five years ago in his successful bid to defend the euro. For OPEC, however, "whatever it takes" may not be enough.

As reported earlier oil surged today, with Brent rising above its 50 and 200 DMA, after Saudi Arabia and Russia announced an agreement that the OPEC production cuts of 1.2MMbbls agreed upon last year in Vienna, should be extended through the end of the first quarter of 2018, effectively assuring that the May 25 OPEC summit later this month will agree on the same. There is, however, a problem: based on the simple math, a simple extension will not be nearly enough to bring the oil market back into balance. 

First there is the problem of excess supply, and not just resurgent US shale production, which is set to surpass an all time high 10 million barrels per day in the near future.

Over the weekend, Libya - the OPEC member with Africa’s largest crude reserves - announced it was pumping more than 814,000 barrels a day, thanks mostly to rising output from two fields that re-started last month, Jadalla Alaokali, a board member at the National Oil Corp., told Bloomberg on Sunday. At the end of April, Libya was producing about 700,000 barrels a day.

While output from the politically divided country is at its highest since October 2014 when it pumped 850,000 barrels a day, in an ideal world its output could grow substantially from here. Prior to the Arab Spring uprising, Libya - which together with Iran and Nigeria was exempted from OPEC’s cuts due to internal strife - pumped as much as 1.6 million barrels a day. It’s targeting production of 1.32 million barrels a day by the end of this year, the NOC said last week in a statement, some 500kb/d higher.

Then there is Nigeria, where the Forcados pipeline came back online last week and the Qua Iboe pipeline is being tested currently, with both together allowing output to reach its pre-disruption level of 1.8 mb/d. The oil ministry said that Nigerian oil output averaged 1.45mb/d suggesting an increase of 300kb/s in the near future is all too possible absent another set of production disruptions.

Of course, in the interim, North American output is booming, and where according to Baker Hughes, the number of US rigs has risen for 17 consecutive weeks, the highest level since the week of April 17, 2015, and the longest stretch of increases in six years.


Furthermore, the U.S. DOE recently published a new forecast that revised the country's oil output up yet again. And yes, it was revised higher. Crude-oil production is now expected to rise by 960,000 barrels a day between December 2016 and December 2017. That compares with a 210,00 barrel a day increase it foresaw just before OPEC's November gathering. Add in a 470,000 barrel a day ramp up in the production of natural gas liquids, and OPEC's entire cut is more than offset.

Then there is OPEC's own forecast, according to which the cartel trimmed its estimate of the need for OPEC crude this year by 300,000 barrels a day. At that level of production - 31.92 million barrels a day - inventories will remain static, assuming demand and non-OPEC supply forecasts are correct. As a reminder, based on secondary sources, OPEC produced 31.74 million barrels a day in April. According to Bloomberg's Julian Lee, simply rolling that level forward for another six months will exhaust the excess at an average rate of 722,000 barrels a day in the second half and will see about 120 million barrels removed from inventories in the nine months begun at the end of March. "That may seem like a lot, but OPEC puts the excess at the end of the first quarter at 276 million barrels -- and that's just in the developed countries of the OECD."

Then there is the question of demand.

We look at India first, where as Reuters' Christopher Johnson points out, citing JBC numbers, oil demand growth continues to slow and is now expected to be only 185,000bpd this year, vs 290,000 in 2016.

Then there is China, where oil imports likewise declined from record highs according to the latest trade data. Buying by China, which overtook the U.S. during the first quarter as the world’s biggest importer, averaged 8.4 million barrels a day in April, down 8.8% from a record the previous month. At the same time, net exports of oil products fell almost 49% from March to 1.01 million tons

The import decline from a record in March was due to seasonal refining maintenance picking up and independent processors, known as teapots, reaching their buying quotas, according to Jean Zou, an analyst at Shanghai-based commodities researcher ICIS-China. “Teapot buying in April eased a bit after the high level in March," Zou said. Imports last month by the independent refiners in Shandong province, where the majority are based, dropped to about 7.8 million metric tons, from 9.9 million in March, she said.

However, even that may mask the true level of underlying demand.

According to researcher SCI99, crude inventories at major ports in Shandong province in East China rose to 9-month high last week, suggesting that much of the newly imported oil is simply being held in inert storage with little downstream demand. Echoing what Zou said, energy research consultancy Energy Aspects said that the increase of crude inventories at major ports in Shandong is linked to uncertainty over import quotas for teapot refiners. “The quotas are a key factor in this build-up,” analyst Michal Meidan said in emailed response to questions Friday, and added that refinery maintenance could also be a factor.

Making matters worse, according to a BMI Research note on Monday, a second round of quotas for Chinese independent refiners won’t provide a “significant” boost to nation’s imports. As a result, the scope for government-set quotas surprising to the upside remains low as Beijing moves to gradually curb import quotas allocated to domestic refiners to manage a persistent refined fuels glut at home.

More to the matter at hand, China’s decision to keep restrictions on teapots from exporting refined fuels independently for 2nd consecutive quarter could also lead to lower crude runs, as exporting fuels through state-owned cos. is both costly and cumbersome, and as competition intensifies in domestic market.

And with a mini-glut of upstream crude already piled up, Chinese demand over the next few months will surely dip, especially if recent teapot quotas are not restored.

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As a result, simply adding up the supply increases among Libya, Nigeria, Iran and US production, offset by the demand reduction in India and China means that merely extending the cuts won't bring oil inventories anywhere close to their five-year average level by the end of December, or even end of March. And, as Bloomberg's Lee also notes, "let's set aside the fact that the five-year average has been inflated by two years of surplus, which means stockpiles will have to come down significantly below that to return to normal levels."

So what does OPEC need to do in addition to extending production cuts? The answer: it needs to double them.

According to Bloomberg calculations, OPEC's own numbers show the group needs to limit its total production to 30.88 million barrels a day from July to deplete the excess OECD inventory - a decrease of 900,000 barrels a day from current levels. But with Libya and Nigeria, which are exempt from the supply-reduction deal, both restoring production after months-long disruptions, deeper cuts will be required still.

Lee's conclusion: "If OPEC wants to drain surplus inventories by the end of the year, its members are going to have to accept some real pain. Even then, the risk is that their actions spur more supply from U.S. shale. It's time for some tough decisions."

Finally, none other than Goldman confirmed as much in a note earlier today, when it specified the two conditions OPEC's production cut will need to meet for the revised extension cuts to work:

For the strategy to work we believe that (1) compliance needs to remain high and (2) long-term oil prices need to remain low to prevent shale producers from ramping up investment significantly more. In fact, an extension of the cuts should go hand in hand with guidance of future production increases by low cost producers, in our view, with an already notable emphasis by Saudi and others that oil prices will likely remain in a $45-55/bbl long-term range, in line with our forecasts

It will take the market time to digest the unrevised math, not to mention the Saudi unwillingness to "accept some real pain." Until then, we expect algos to ignite a buying frenzy every time bullish OPEC headlines cross the tape, as has been the case for the past year. In the meantime, having flipped from near-record long positions, futures specs have seen their net long positions tumble in recent weeks. We expect this to reverse as the momentum resumes chasing price higher once again, until yet another surge in bullishness leads to mass liquidations, resulting in yet another mini flash crash such as the one observed two weeks ago when Pierre Andurand - one of the world's biggest oil bulls and largest oil hedge fund traders - ended up liquidating his long positions.