OPEC surprised the market with its first production cut in eight years last week, representing approximately 720kbbld, and, more importantly, marked a significant change in policy. Although a surprise, the chances of something happening at this meeting were a lot higher than during OPEC’s April 2016 meeting in Doha.
Two things had to be present to create a climate where action, a freeze or a cut, could take place. Firstly, OPEC had to be willing and secondly, there had to be signs that Iran, Iraq and Saudi, the major protagonists, were facing production exhaustion. The will was indisputable. Saudi, for example, is suffering extreme budget deficits thanks to the haemorrhaging of its oil revenue (30 per cent of GDP) and has had to suspend or cut many of its social spending programmes, even cutting its ministers salaries by 20 per cent and overtime bonuses by up to 50 per cent…the willing was there!
The size of the cut is probably not the most important issue here. What the cut says about OPEC’s ability to continue growing production is the most important issue. We had actually built into our expectations, ignoring any OPEC policy decision, that the group would be producing c. 430kbbld less by the end of 2016 than they are now. If the major three protagonists had capacity to grow production much further, we believe that the chances of a deal would have been significantly reduced.
There were certainly signs of production exhaustion; Saudi, Iran and Iraq have grown OPEC production by almost 3mbbld since OPEC’s notorious November 2014 meeting, when they refused to cut.
Saudi is, arguably, producing at full tilt and had to supplant organic production growth with net monthly draws from its inventories for seven consecutive months from November 2015 to May 2016. This is the first time, since records began, that it has drawn from inventory for more than three consecutive months.
In 2015, international oil companies operating in Iraq were asked to suspend oil projects as the Iraqi government did not have the revenue to pay them. The number of active rigs in Iraq is subsequently down from 98 to 26.
Iran, the last of the three pillars of production growth, has almost reached its medium output target of 4mbbld and has seen a distinct slowdown in the pace of its oil production growth from 175kbbld in the first four months since sanctions were lifted in January 2016 to 30kbbld growth monthly subsequently. OPEC spare capacity is also at its lowest level in eight years; interestingly, the date when it last agreed to cut.
The chances of a slowdown were inevitable. The next stage of the decision is the detail and it will be interesting to see who is carrying the burden. Over the last five years following the summer months to the end of the year Saudi, has on average, dropped production by 283Kbbld, so we expect that it will make up the majority of the number.
Where does this leave markets?
For the rest of the oil producing world, prices down in the US$40s made little to no economic sense. The industry has pulled in its purse strings faster and harder than has ever been seen. The hangover of 2014’s US$100bbl and the resulting investment into new projects will see a good number of non-OPEC projects being completed in 2017 and contributing c. 2.1mbbld production.
We then start hitting the big bump in the road from 2018 to 2020, where we estimate that half as many projects will be completed as compared to the 2013-2017 average – a direct result of the decimation in capex. The 2.1mbbld of production that is now set to come on in 2017, looks like it will not only be partially offset by the 720kbbld cut by OPEC, but also by an increase in the decline rate due to a cratering in production spend.
Infill drilling, amongst other things, is an important production spend which reduces the decline rates of mature fields and production. This correlation has been highlighted by Rystad, an oil consultancy firm, who expect the 15mbbld production that we get from mature oil fields to decrease at an accelerated rate of 10%, or 1.5mbbld; infill drilling decreased by 59 per cent in 2015.
The existing lack of spend from non-OPEC and OPEC ex Middle East (ME), combined with the tacit admission that OPEC (ME) production growth is effectively exhausted, should accelerate the draw down in commercial inventories, which are elevated by historical standards. The shift in OPEC policy suggests that we are likely to see that equilibrium reached a few quarters earlier, perhaps by the end of 2017. It will also likely mean that short-cycle shale producers in the US will be called upon to meet demand growth, which is slated to register around 1.2mbbld over the next year. We have already started seeing budding signs of with the slight upturn in US rig counts (primarily in the Permian basin). Consequently, the call on OPEC has categorically been shifted across the seas to the US, something we are invested to capture within the Fund.
All in all this is, assuming that OPEC follow through with the majority of the cut, unequivocally, bullish for the oil sector – particularly US shale producers.
Richard Robinson is manager of the Ashburton Global Energy fund.