OPEC extended oil production cuts last week and oil prices plunged.

OPEC’s goal was to keep a floor under current prices but the market expected the cartel to move prices higher through inventory reduction. OPEC was satisfied with greater revenues from higher prices compared to a year ago, but the market wanted deeper production cuts. OPEC takes the long view but the market is concerned with the near term. OPEC extended the cuts and the market reacted with lower prices.

Analysts have created the unfounded but widely accepted belief that OPEC has a strategy that involves a price war with U.S. tight oil producers and a play for greater market share. The cartel’s inaction before last November’s production cuts reflected an unwillingness to repeat the mistake of cutting 14 million barrels per day between 1980 and 1985 with little effect on world over-supply and financial damage for OPEC members.

OPEC’s members have disparate needs and interests. They are not unified behind any mission statement or over-arching principles except to maximize revenues and minimize losses. IEA calculated that recent production cuts earned the cartel an additional $75 million per day year-over-year in the first quarter of 2017. It also was a gift to competitors so the idea of making deeper cuts had no cost benefit.

Last week’s price plunge was the third time in 2017 that prices have adjusted downward toward the $45 per barrel level suggested by market fundamentals (Figure 1).

At first, OPEC did nothing after oil prices collapsed in 2014. When prices fell to $26 per barrel in early 2016, OPEC floated the idea of a production freeze and that established a floor from which prices increased to more than $50 per barrel during the first half of the year (Figure 2).

In June 2016, markets lost faith in OPEC’s resolve and prices fell from $51 to below $40 per barrel. OPEC then set another price floor by announcing tentative agreement on a production cut. When prices fell below $43 in November, another price floor was created when OPEC enacted production cuts.

The world price floor moved up almost 75% from $26 to $45 per barrel in just over a year. That looks like success to me. Production cuts were extended last week to reinforce the current $45 floor without helping the competition too much—not to meet market expectations of higher prices.

Oil traders understand this better than analysts and they began unwinding their long positions in February. Net long positions on WTI futures have fallen 25% since then but most of the sell-off has been since April 2017 (Figure 3).

Reasons For Lower Prices

Many analysts proclaim that Brent prices will be near $65 by the end of the year. Although IEA and EIA production data suggests good OPEC compliance with the November agreement, global markets remain well supplied. OPEC shipments to its biggest customers—the U.S. and China—are more than 10% higher than a year ago. Production cuts are not reflected in well-supplied markets nor are global inventories falling much.

Market concerns are valid that U.S. tight oil output may cancel OPEC production cuts. Despite frack crew shortages and limits to pressure pumping equipment, 2017 well completion rates appear strong in the Bakken, Eagle Ford and Permian basin plays (Figure 4).

OECD comparative inventory for April was approximately 300 million barrels above the 5-year average. The price vs. comparative inventory yield curve suggests that Brent is as much as $7 per barrel over-valued at $52 per barrel (Figure 5). If recent withdrawal levels hold, it may take a year to reduce inventories to levels that support $65 Brent prices. On the other hand, EIA forecasts suggest relatively minor OECD inventory drawdowns through year-end and rising inventories in 2018.

World production surpluses have been falling for the last year but EIA expects these to start increasing as early as May (Figure 6). Surpluses may persist through the middle of 2018 before decreasing again. Its forecast is for Brent prices to remain less than $60 per barrel through the end of 2018.

Recent modeling by Macquarie Research supports this view and predicts sub-$60 Brent prices through the second quarter of 2019 (Figure 7).

Although OPEC cuts appear to be real, Macquarie sees U.S., Russia and Brazil production growth as bearish drivers on price. Maintaining OPEC cuts beyond the end of 2017 will be difficult and recent talk of selling half of U.S. strategic reserves potentially puts an additional 300 million barrels of oil on an already over-supplied market.

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