Orlando's Outlook: OPEC's perfect storm


Bottom line: Crude oil prices have surged by more than 35% over the past five months to nearly $58 per barrel, due to the perfect storm of stronger global demand, tighter supply, a relatively weaker U.S. dollar and the advent of new geopolitical risks. In addition, the Saudi Aramco IPO and the Russian presidential election remain on the 2018 horizon. Officials from the 14 nations that comprise the Organization of the Petroleum Exporting Countries (OPEC), along with 13 non-OPEC countries including Russia, will convene next week in Vienna, Austria, to discuss the possible extension of their current agreement to cut production by 1.8 million barrels a day until the end of 2018. So investors will remain fixated on the results of that important Nov. 30 meeting and the potential sustainability of this year’s crude oil rally into 2018 and beyond.

Crude rebounds Crude oil prices as measured by West Texas Intermediate soared by nearly 38%, from $42 per barrel on June 21 to almost $58 earlier this month. Lagging gasoline prices rose by 20%, from $2.23 per gallon on July 4 to a peak of $2.67 in early September. In our view, the bulk of that near-term spike in gas prices was due to Hurricane Harvey, as some 25-30% of refinery capacity in Houston was forced offline temporarily due to the storm. As some of that refinery capacity has since come back on line, gas prices have eased by about 5% over the past two months, to about $2.53 per gallon nationally now.

Over the river and through the woods Despite the highest Thanksgiving gas prices since 2014, the combination of a 17-year low jobless rate (4.1%) and strong consumer confidence has likely sparked the busiest Thanksgiving travel season in 12 years, as the American Automobile Association (AAA) projects that nearly 51 million Americans will travel 50 miles or further this holiday weekend, a 3.3% year-over year (y/y) increase. Air travel is expected to be even busier, with nearly 4 million travelers (a 5% y/y increase) enjoying the cheapest average fares since 2013.

Strong business & consumer sentiment fueling gasoline demand:

  • Leading economic indicators hit a new 58-year cycle high in October with a 1.2% month-over-month increase to 130.4.
  • Conference Board consumer confidence soared to a new 17-year cycle high of 125.9 in October.
  • Michigan consumer sentiment spiked to a 13-year high of 100.7 in October, but slipped this morning to a still better-than-expected 98.5 in November.
  • NFIB small business optimism roared to a 12-year high of 105.9 in January 2017, up sharply from a cycle trough of 94.1 in September 2016, but it has since eased slightly to 103.8 in October.

Meet me in Vienna At the beginning of 2017, OPEC nations and 11 non-OPEC oil-producing nations (including Russia) agreed to jointly cut production 1.8 million barrels a day (about 1.8% of global oil supply). They subsequently extended those cuts last May for nine months into March 2018. It was OPEC’s first coordinated joint reduction in crude-oil production in eight years, and it has positively reduced the global oversupply of oil. Two-thirds of the cut (1.2 million barrels per day) came from OPEC, with Saudi Arabia shouldering most of it, and one third (600,000 barrels) came from the non-OPEC countries, as Russia accounted for half. At present, there are 14 official OPEC nations and 13 non-members who are participating in the production cuts, collectively accounting for about 52 million barrels per day of production, or roughly 53% of global demand of 98 million barrels. Speculation is next week’s meeting will extend those cuts through calendar 2018, which is consistent with our constructive outlook.

Making progress on storage goals OPEC’s stated goal is to reduce storage levels for the industrialized nations that comprise the Organization for Economic Cooperation and Development (OECD) back to 5-year average levels. Last year, before the first accord was put into place, OECD oil stocks were a bloated 300 million barrels above the 5-year average. Today, that glut has been cut nearly in half but is still 170 million barrels above the 5-year average.

Saudis remain motivated At 9.8 million barrels per day, Saudi Arabia is the world’s second-largest crude oil producer and the largest within OPEC. It has cut its production by about 900,000 barrels per day from last year’s production peak to help engineer higher oil prices of perhaps $60 per barrel next year. Its motivation is to execute a successful initial public offering (IPO) during the second half of 2018 of a 5% stake in its national oil company, Saudi Aramco, whose estimated $2 trillion value could raise $100 billion to help balance its budget deficit. The Aramco IPO is thought to be the cornerstone of Saudi Arabia’s “Vision 2030,” a longer-term strategy to reshape the economy and reduce its dependence on oil revenues.

In September, Saudi Arabia sold $12.5 billion of bonds, its largest sovereign-debt issuance in 2017, to help finance and reduce the country’s $53 billion budget deficit. With the hoped-for IPO, Saudi Arabia is targeting a balanced budget by 2020.

Russia still a player The world’s largest crude-oil producer at 10.5 million barrels per day, Russia’s emerging-market, commodity-centric economy was driven into recession by the recent plunge in oil prices, from $108 in 2014 to $26 in 2016. With significant oil-related operating leverage, every $10 change in the price of crude oil weakens or improves Russia’s budget by $30 billion. So with Russian President Vladimir Putin planning to run for re-election to another six-year term in late March 2018, it’s easy to understand why Russia has pledged to cooperate with the OPEC cuts through its own 300,000-barrel-per-day reduction. Higher energy prices and a stronger economy put Russian voters in a more positive frame of mind when they head to the polls next March.

Geopolitical risks abound Activity in recent months likely helped to boost crude oil’s second-half rally, including:

  • The oil-rich Kurds voted nearly unanimously to break away from Iraq in an independence referendum in September, sparking military clashes between Iraqi government troops and forces from the semiautonomous Kurds, which resulted in some oil production and export disruptions. At about 4.5 million barrels per day, Iraq is the world’s fourth-largest crude oil producer, and the Kurdish region produces most of Iraq’s crude oil.
  • Saudi Arabia blamed rival Iran (the world’s fifth-largest crude-oil producer at 4 million barrel per day) for providing neighboring Yemen with missiles that a rebel group fired at Riyadh’s airport in Saudi Arabia earlier this month.
  • Saudi Arabia’s Crown Prince Mohammed bin Salman launched an aggressive consolidation of power in early November, detaining dozens of princes, government officials and business people in a massive anti-corruption effort to re-shape the Saudi economy.

Fracking remains the wild card The U.S. is the world’s third-largest crude producer with about 9.6 million barrels of oil produced each day. As the price of crude oil collapsed from 2014 to 2016, uneconomical wells were shut down, and land-based domestic rigs (for both oil and gas) plunged from a peak of about 1,900 rigs at the end of 2014 to less than 400 in the second quarter of 2016. But with the price of crude more than doubling since then, the rig count has soared back to 923, and fracking operators have become much more efficient.

Conclusion Because U.S. energy companies have benefited significantly from the sharp second-half recovery in crude-oil prices this year, and because they are not part of the voluntary OPEC and non-OPEC production cuts, the market risk is that they will not restrain production, which will eventually cap prices, perhaps at or near $60 per barrel, due to greater U.S. supply flooding the market. So with Russia and Saudi Arabia holding back their production levels into next year, the U.S. could eventually become the world’s largest crude producer. As a result, we do not expect crude-oil prices to revisit their elevated 2014 levels. But we do expect prices to remain at or near current $60 levels, at least until the Russian election and the Aramco IPO are behind us next year.

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