Four exit strategies for OPEC+ deal in 2018

Baku, Azerbaijan, Feb.1

By Leman Zeynalova – Trend:

The status of the OPEC, non-OPEC production cut deal will remain central to the global oil market in 2018, according to the report released by BMI Research, (a Fitch Group company).

As the market continues to rebalance, attention will turn to potential exit strategies for the group, said the report obtained by Trend.

Below BMI Research analysts discuss four main pathways for exiting the deal and the implications of each.

“Our core view and 2018 price forecasts assume that the production cut deal holds in its current form until December. However, we see a significant risk that the deal is exited early, at the OPEC ordinary meeting in June. It is also possible that the deal will collapse in advance of the meeting, or that circumstance will force its extension to 2019, although we assign a low probability weighting to both,” said the analysts.

1. Deal Collapse

Market conditions are strongly bullish. Oil demand growth accelerates in both developed (DM) and emerging (EM) markets, while supply growth disappoints, due to large-scale unplanned outages and delays in the commissioning or ramp-up of greenfield projects.

The combination of accelerating demand growth and soft supply growth drives OECD crude inventories down to their five-year seasonal average in Q1, while Brent crude rallies into the range of $70-$80 per barrel. Rising prices trigger an aggressive response from shale producers in the US and incentivizes cheating amongst OPEC members and Russia (OPEC +1). Compliance worsens substantially month-on-month provoking retaliation from Saudi Arabia and marking a de facto end to the production cut.

'Deal Collapse' is the most bearish of the four scenarios. Prices would be declining from the highest base - plausibly in excess of $80 per barrel. The aggressiveness with which OPEC+1 returned its barrels to market would determine the depth and duration of the decline.

Our demand and supply growth forecasts are, respectively, well-above and -below market consensus and 'Deal Collapse' requires substantially higher consumption and lower production than we currently forecast.

2. June Ending

Global fuels consumption growth accelerates strongly, led by resurgent EM demand. DM growth decelerates, but stays positive overall as building economic momentum offsets the impact of rising fuels prices domestically.

Renewed outages in Libya and Nigeria and aggressive decline rates in parts of Latin America and Asia tighten the market, offsetting a strong recovery in US shale. Soft inventory builds in Q1 and aggressive withdrawals in Q2 pull OECD stocks down to their seasonal norms, lifting prices. A strong demand and pricing environment weakens compliance amongst those countries with the capacity for growth. Uneven compliance levels fray cohesion in the OPEC+1 and Saudi Arabia fails to secure consensus to hold the deal - in its current form - through to December.

Given that the deal is priced in until end-2018, the 'June Ending ' scenario is on balance, bearish for Brent. A lot will hinge on how OPEC manages the exit.

As with the 'Deal Collapse' scenario, declines will happen from a high base ($70-$80 per barrel).

There are relatively few members of the OPEC +1 that have the capacity to substantially raise their output. Spare capacity is dominated by Saudi Arabia, which remains strongly committed to the deal. Russia, Kuwait, Iraq and the UAE hold the bulk of the remainder. With the exception of Iraq, substantial compliance slippage is, in our view, unlikely in these markets. Russia has signaled an intent to extend cooperation with OPEC beyond the cut deal, whilst OPEC policy in Kuwait and the UAE tends to align with that in Saudi Arabia.

3. December Ending

Broad-based economic growth and a continued pick up in global trade support accelerated oil consumption growth. Supply remains relatively comfortable, despite high overall compliance with the OPEC, non-OPEC production cut deal. US shale leads strong growth in non-OPEC supply and prevents the normalization of OECD crude inventories until H218.

This is the most price-neutral of the four scenarios, given that it reflects the consensus expectation of the market. However, as with the 'June Ending' scenario, the form that exit takes will largely decide its impact on price. Historically, the group has been better able to maintain its cohesion in a rising oil price environment and we expect Saudi Arabia to effectively manage the group's exit from the cut in 2019.

4. Deal Extension

Global economic momentum fails, dragging down on demand for fuels; EM growth flattens, while DM consumption falls into decline.

Large greenfield additions and historically low global supply outages tip the market deeper into surplus. Weaker prices restrain production in the US, but low breakevens fuel substantial year-on-year growth in the core of the Permian. High compliance with the production cut deal is insufficient to prevent heavy seasonal builds and soft seasonal draws in OECD stocks across 2018 and, as a result, inventory levels fail to normalize this year.

This is the most bullish of the four scenarios and would likely trigger a significant rally in Brent.

---

Follow the author on Twitter: @Lyaman_Zeyn

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