Orlando's Outlook: Saudis get their cut

12-09-2016

 

Bottom line: Crude oil prices (as measured by West Texas Intermediate, or WTI) have soared 25% since mid-November to $52 per barrel, as the 14 oil-producing nations that comprise the Organization of the Petroleum Exporting Countries (OPEC) agreed to their first coordinated production cut in eight years. OPEC plans to collectively reduce its output by 3.6% (1.2 million barrels per day) for six months starting on Jan. 1, and the cartel will meet again in late May to potentially extend the cuts another six months.  Moreover, at a meeting tomorrow in Vienna, the Saudis are hoping non-OPEC oil-producing nations (including Russia) will agree to kick in with an additional 600,000 barrel-per-day cut. To be sure, a reduction in supply of this magnitude, combined with the improved demand driven by the stronger domestic economic growth we envision from “Trumponomics” over the next two years, will likely provide support for energy prices at higher levels. But the risk, of course, is compliance, as oil producers—both OPEC members and non-members alike—have a long and distinguished history of fudging their quotas. So only time will tell if these broad production cuts desperately orchestrated by Saudi Arabia successfully achieve their desired effect.   

Saudi Hail Mary OPEC’s collective production cut, from 33.8 million barrels per day in October (about a third of global supply) to 32.6 million, will reduce the global supply of crude oil by about 1%. But Saudi Arabia is clearly taking the lead here, cutting its own production by nearly 500,000 barrels per day, down from nearly 10.6 million barrels per day. So while its current production comprises 31% of the OPEC total, the Saudis are contributing 41% of the total cut.  

As we’ve discussed before, the Saudis are desperate to engineer higher oil prices of at least $50 per barrel to balance a budget deficit of roughly $98 billion for each of the last two years and keep social unrest at bay within the country. The Saudis also are planning an initial public offering (IPO) of a 5% stake in their national oil company, Saudi Aramco, by 2018. Its value approximates $2.5 trillion, which means the IPO could raise $125 billion. In addition, they borrowed $10 billion from banks in April, sold $17.5 billion in sovereign bonds in October and hope to institute a 5% value-added tax (VAT) by 2018.

Who else is participating? True, the Saudis are reclaiming their mantle as OPEC’s swing producer to achieve higher oil prices. But the current deal could not work if the Saudis’ three close Persian Gulf Arab allies—Kuwait, Qatar and the United Arab Emirates (UAE), collectively known within OPEC as the “Gulfies”—did not collectively contribute cuts of another 300,000 barrels per day.

That’s because Nigeria, Libya and Indonesia requested and were granted exemptions from any cuts so they can continue to ramp production due to their own country-specific problems. Moreover, Iran (Saudi Arabia’s long-time nemesis) was similarly exempt from any production cuts and will actually be permitted to add another 100,000 barrels per day to restore production to pre-nuclear sanction levels of about 3.8 million barrels per day. Iraq and Venezuela have reluctantly agreed to cut their own production by roughly 200,000 and 150,000 barrels per day, respectively.  

What about non-OPEC cuts? Russia remains the largest crude-oil producer in the world, currently at a post-Soviet high of about 11.0 million barrels per day. Its commodity-centric economy, which is in recession, would certainly benefit from higher energy prices. So Russian President Vladimir Putin has pledged to cooperate with the Saudi cuts, contributing a 300,000-barrel-per-day reduction, which could boost his lagging popularity if prices remain elevated.

According to our research friends at RBC Capital Markets, Mexico will propose a cut of 150,000 to 200,000 barrels per day, Azerbaijan by 80,000 barrels, Oman by 50,000 barrels, and 20,000 barrels collectively from Egypt, Colombia and Bahrain. All of these non-OPEC cuts, which total about 600,000 barrels per day, will be discussed and potentially finalized at tomorrow’s meeting in Vienna. The key may well be for OPEC and Saudi Arabia to demonstrate some flexibility and accept natural declines in these countries’ outputs as formal “cuts.” The Saudis, for example, would normally cut their oil production sharply in the colder winter months when they need to burn less oil to generate electric power to run their air conditioning.

In terms of compliance among participating countries, the Qatari oil minister has created a monitoring committee of oil officials from Algeria, Venezuela and Kuwait, although penalties for possible compliance violations were not outlined.  

How might this impact U.S. production? The U.S. is the world’s third-largest crude producer and reached peak oil production of about 9.6 million barrels per day in the summer of 2015, with a land-based domestic rig count (for both oil and gas) that similarly peaked at about 1,900 rigs at the end of 2014. But as crude oil prices plunged by 75% from $108 per barrel in June 2014 to $26 in February 2016, U.S. energy companies cut their uneconomical rigs by nearly 80% to a record low of 404 rigs in June 2016, reducing oil production to 8.4 million barrels a day this past summer. But as oil prices have doubled over the past nine months, the rig count has risen by 50% to 597 at present, and crude oil production is back to 8.7 million barrels per day. We continue to believe that sustained higher global crude-oil prices will bring more U.S. frackers back into production, which could once again pressure prices with higher levels of supply.

‘Trumponomics’ and the Fed—a double-edged sword for crude prices We continue to expect that President-elect Trump’s fiscal-policy priorities will include corporate-tax reform, less regulations, repatriation of overseas corporate cash, infrastructure spending, and a more muscular defense, all of which collectively should boost GDP growth from an anemic 2% run rate at present to at least a 3% trend-line growth rate—or perhaps to a healthier 4% level—over the next two years.

Consequently, we also expect the Federal Reserve to raise interest rates by a quarter point at its Dec. 14 meeting, followed perhaps by two quarter-point rate hikes next year. So the prospect of stronger economic growth and tighter monetary policy should keep the dollar relatively strong, which could negatively impact oil prices, whose relationship with the dollar tends to be inverse.

Winter weather wild card Due to a weak La Nina, the long-term weather forecast is that we’re in for a brutal winter, with much more frigid and snowier conditions in the Upper Plains, Midwest, Mid-Atlantic and Northeast. Last winter, in sharp contrast, was relatively mild, so the comparison is to prepare for winters such as we suffered through in the two previous years. Remember the Polar Vortex? If that forecast proves accurate, then that’s positive for crude-oil prices, due to the incremental demand for home heating oil, which could accelerate the global supply/demand balance of crude oil and boost prices more quickly. So even if there’s some cheating among OPEC and non-OPEC members with regards to these recent production quotas, a colder winter could sop up any unintended oversupply. 

Conclusion We continue to believe that crude-oil prices will remain within a relatively narrow trading range of perhaps $40-60 per barrel through the end of 2017. If there’s widespread cheating among oil-producing nations with regard to their production quotas, the winter turns out to be mild and we don’t get the economic traction we expect from the new Trump administration, then we may well retest the low end of that range. But if everyone sticks to their bargain, U.S. economic growth begins to perk up over the course of next year and we get the brutal winter that’s been forecast, then WTI may revisit their 2015 highs at $60. The Saudis have clearly invested a tremendous amount of political capital to orchestrate a rise in prices into the higher end of that range, which will benefit all energy producers. But only time will tell if their strategy and their sacrifice works.