OPEC Oil Production Cuts: Our Analysis
At the long-awaited meeting on 4 June 2023, OPEC and its allies decided to extend the 2 million oil production cut that was agreed in October 2022 until the end of 2024. Yet, its new quotas published alongside the decision finally presented the much-needed revision for some countries that have been suffering from a chronic bout of underperformance, particularly the West Africans. The constant below-the-baseline production has so far rendered ineffective a large portion of the OPEC cuts, diminishing the credibility of the organisation.
The revised baselines (see table below) will take effect as of 2024 and they show a total revision of 622,000 barrels per day in OPEC (10 countries excluding Venezuela, Iran, and Libya). The net figure is -422,000bpd as Angola and Nigeria saw their baseline drop significantly. The 200,000bpd is UAE’s gain as it will increase the baseline production quota for 2024. The UAE surely wants to produce more, monetising its increasing capacity as soon as possible with continued investments. The disagreement between UAE and Saudi Arabia in 2021 over the increase in baseline production (UAE secured 3.5mbpd from a previous level of 3.16mbpd) is still fresh in one’s memory. Moreover, 3.2mbpd allocated to UAE for the 2024 quota is far from the country’s target of 5mbpd by 2025.
Source: OPEC, AlphaValue
The bolder decision came from Saudi Arabia, the de facto leader of the group, which pledged to cut 10% of its current production (1mbpd) in July. This could be extended further, and this is not a dim possibility.
What happened to Russia? Simply nothing. The Russian quota for 2024 was revised down to the country’s current crude oil production but that is subject to multi-partite verification and transparency.
Lastly, the 9 OPEC+ members that agreed on voluntary cuts in April, having taken the market by surprise, decided to extend the voluntary cut of 1.66mbpd through 2024.
Source: OPEC, AlphaValue
Analysis
The supply outlook
Before trying to understand the last OPEC+ meeting and its reverberations across the sector, we summarise our take as follows:
1) Our 2023 average price forecast at $85/bbl remains unchanged for now with a potential revision in July.
2) OPEC has a China problem, and it is not only about demand.
3) June is likely to be a painful month despite the “cut” from Saudi Arabia, and European oil equities could see a further decline (-5%), offering an opportunity for an entry point.
4) Inventory draws are likely to start deepening in July and could continue for the rest of the year.
A first look at the 2024 production quotas gives the impression that the OPEC+ members agreed on a 1.6mbpd cut. This is, however, rather illusional as it is just a downward adjustment for countries that have been unable to produce at their full capacity.
How much of the voluntary cuts of 1.6mbpd, announced in April to be applicable as of May 2023 and extended through 2024, will materialise is anybody’s guess.
The heavy burden, therefore, seems to be falling on Saudi’s shoulders. In July, the country will reduce output by 1mbpd and when Saudis commit, they deliver. Therefore, it is safe to count on an output decline at the beginning of Q3. This decline, as opposed to Russian cuts, is likely to diminish exports in July to as low as 6.3mbpd, hence the global supply reduces.
What does the OPEC+ decision say?
The latest OPEC+ decision was one of the most difficult to decipher as it had several complicated segments. Our brief understanding: OPEC producers are trying to reconcile short-term worries and price developments with long-term insurance for demand longevity.
The fact that the cut is shouldered by Saudi Arabia demonstrates that the OPEC leader is aiming to control the current and short-term narrative. Since Q4 FY22, the Saudi energy minister and several OPEC ministers have criticised short sellers and repeatedly said that the paper market does not reflect the reality of the physical market. Indeed, the physical market for June is quite weak with around 50 million barrels unsold. It is also true that the paper market is captivated by the expectations of a recession in the US in H2 and lower demand in Europe. Yet, this is not a war of narrative that OPEC should get itself into.
Each decision to cut output since Q4 has brought more disarray to the market. An immediate upward price reaction after the April announcement proved quite short-lived as we predicted at the time. The current upward pressure after 4 June has also remained weak and, in our view, the prices would remain in the range of $75-78/bbl anyway.
The bells toll for inventories
The current level of OPEC production at 28.5mbpd – without factoring in any pledged cut – points to a serious supply deficit in H2 based on OPEC’s own global demand forecast.
OPEC and IEA expect oil demand to average at 102mbpd. Based on quarterly OPEC estimates and OPEC’s current production of 28.5mbpd, the market is looking at a supply deficit of 1.55mbpd in Q3 and 1.88mbpd in Q4 this year. In plain English, this means that OPEC has to increase production in H2 OR inventories have to decline. Our calculation based on the figures below shows that global inventories could deplete by 308 million barrels in H2 – this will be unprecedented.
Source: OPEC, AlphaValue
OPEC has a China problem
In our view, the market has slightly overstated the acceleration of the Chinese economy. The monthly PMI numbers are a testament to this verdict.
Source: China National Bureau of Statistics
The weak new export order index and declining construction index prove the points mentioned above. Yet, this is still contrarian to what we see in the media headlines about Chinese demand and street consensus.
Chinese demand is certainly growing, reaching an all-time high of 16 million barrels in April. However, prudence must be applied to the top-line figures because demand does not mean consumption. Unfortunately, for us, China does not release petroleum consumption data. Inventory building, however, gives a strong clue. Kpler data shows Chinese crude inventories reached 996 million barrels – higher than US commercial and SPR totalling 813 million barrels.
With the ongoing uncertainty and the expected uptick in construction activity together with domestic demand, we are taking a more cautious view of Chinese demand growth.
Steep backwardation is what producers and equities need
So far, we have used the term market management a couple of times. But, what does it mean in the context of OPEC? The keyword is backwardation.
The market structure of steep backwardation is every commodity producer’s favourite, mostly OPEC oil producers. Backwardation means the front end of the futures curve has higher prices than the back end.
OPEC producers do not hedge their production and they mostly sell through term contracts tied to a dated Brent price or another regional benchmark. As their sales are very much linked to the spot or prompt prices, backwardation allows low-cost OPEC producers to sell their production at a lucrative price.
The futures curve has been quite weak following a quick fix in April, the market even moved to contango at the end of May before the OPEC+ meeting. At present, prompt prices are higher than future prices.
Source: Bloomberg, AlphaValue
Last word on equities
The gap between Oils under our coverage and the Stoxx 600 has widened to the detriment of the sector as oil and gas prices have come down and historic 2022 profits will not be repeated. We have, however, repetitively said that Oils have been through a regime change. It is no longer about volume but about value. The management of companies religiously implements this new mantra: forget growth, extract cash, pay out massively, and invest in the most lucrative upstream.
Source: AlphaValue
**This is just a summary of the full research. If you are interested to get access to the full research, valuations etc please contact us**
The revised baselines (see table below) will take effect as of 2024 and they show a total revision of 622,000 barrels per day in OPEC (10 countries excluding Venezuela, Iran, and Libya). The net figure is -422,000bpd as Angola and Nigeria saw their baseline drop significantly. The 200,000bpd is UAE’s gain as it will increase the baseline production quota for 2024. The UAE surely wants to produce more, monetising its increasing capacity as soon as possible with continued investments. The disagreement between UAE and Saudi Arabia in 2021 over the increase in baseline production (UAE secured 3.5mbpd from a previous level of 3.16mbpd) is still fresh in one’s memory. Moreover, 3.2mbpd allocated to UAE for the 2024 quota is far from the country’s target of 5mbpd by 2025.
Source: OPEC, AlphaValue
The bolder decision came from Saudi Arabia, the de facto leader of the group, which pledged to cut 10% of its current production (1mbpd) in July. This could be extended further, and this is not a dim possibility.
What happened to Russia? Simply nothing. The Russian quota for 2024 was revised down to the country’s current crude oil production but that is subject to multi-partite verification and transparency.
Lastly, the 9 OPEC+ members that agreed on voluntary cuts in April, having taken the market by surprise, decided to extend the voluntary cut of 1.66mbpd through 2024.
Source: OPEC, AlphaValue
Analysis
The supply outlook
Before trying to understand the last OPEC+ meeting and its reverberations across the sector, we summarise our take as follows:
1) Our 2023 average price forecast at $85/bbl remains unchanged for now with a potential revision in July.
2) OPEC has a China problem, and it is not only about demand.
3) June is likely to be a painful month despite the “cut” from Saudi Arabia, and European oil equities could see a further decline (-5%), offering an opportunity for an entry point.
4) Inventory draws are likely to start deepening in July and could continue for the rest of the year.
A first look at the 2024 production quotas gives the impression that the OPEC+ members agreed on a 1.6mbpd cut. This is, however, rather illusional as it is just a downward adjustment for countries that have been unable to produce at their full capacity.
How much of the voluntary cuts of 1.6mbpd, announced in April to be applicable as of May 2023 and extended through 2024, will materialise is anybody’s guess.
The heavy burden, therefore, seems to be falling on Saudi’s shoulders. In July, the country will reduce output by 1mbpd and when Saudis commit, they deliver. Therefore, it is safe to count on an output decline at the beginning of Q3. This decline, as opposed to Russian cuts, is likely to diminish exports in July to as low as 6.3mbpd, hence the global supply reduces.
What does the OPEC+ decision say?
The latest OPEC+ decision was one of the most difficult to decipher as it had several complicated segments. Our brief understanding: OPEC producers are trying to reconcile short-term worries and price developments with long-term insurance for demand longevity.
The fact that the cut is shouldered by Saudi Arabia demonstrates that the OPEC leader is aiming to control the current and short-term narrative. Since Q4 FY22, the Saudi energy minister and several OPEC ministers have criticised short sellers and repeatedly said that the paper market does not reflect the reality of the physical market. Indeed, the physical market for June is quite weak with around 50 million barrels unsold. It is also true that the paper market is captivated by the expectations of a recession in the US in H2 and lower demand in Europe. Yet, this is not a war of narrative that OPEC should get itself into.
Each decision to cut output since Q4 has brought more disarray to the market. An immediate upward price reaction after the April announcement proved quite short-lived as we predicted at the time. The current upward pressure after 4 June has also remained weak and, in our view, the prices would remain in the range of $75-78/bbl anyway.
The bells toll for inventories
The current level of OPEC production at 28.5mbpd – without factoring in any pledged cut – points to a serious supply deficit in H2 based on OPEC’s own global demand forecast.
OPEC and IEA expect oil demand to average at 102mbpd. Based on quarterly OPEC estimates and OPEC’s current production of 28.5mbpd, the market is looking at a supply deficit of 1.55mbpd in Q3 and 1.88mbpd in Q4 this year. In plain English, this means that OPEC has to increase production in H2 OR inventories have to decline. Our calculation based on the figures below shows that global inventories could deplete by 308 million barrels in H2 – this will be unprecedented.
Source: OPEC, AlphaValue
OPEC has a China problem
In our view, the market has slightly overstated the acceleration of the Chinese economy. The monthly PMI numbers are a testament to this verdict.
Source: China National Bureau of Statistics
The weak new export order index and declining construction index prove the points mentioned above. Yet, this is still contrarian to what we see in the media headlines about Chinese demand and street consensus.
Chinese demand is certainly growing, reaching an all-time high of 16 million barrels in April. However, prudence must be applied to the top-line figures because demand does not mean consumption. Unfortunately, for us, China does not release petroleum consumption data. Inventory building, however, gives a strong clue. Kpler data shows Chinese crude inventories reached 996 million barrels – higher than US commercial and SPR totalling 813 million barrels.
With the ongoing uncertainty and the expected uptick in construction activity together with domestic demand, we are taking a more cautious view of Chinese demand growth.
Steep backwardation is what producers and equities need
So far, we have used the term market management a couple of times. But, what does it mean in the context of OPEC? The keyword is backwardation.
The market structure of steep backwardation is every commodity producer’s favourite, mostly OPEC oil producers. Backwardation means the front end of the futures curve has higher prices than the back end.
OPEC producers do not hedge their production and they mostly sell through term contracts tied to a dated Brent price or another regional benchmark. As their sales are very much linked to the spot or prompt prices, backwardation allows low-cost OPEC producers to sell their production at a lucrative price.
The futures curve has been quite weak following a quick fix in April, the market even moved to contango at the end of May before the OPEC+ meeting. At present, prompt prices are higher than future prices.
Source: Bloomberg, AlphaValue
Last word on equities
The gap between Oils under our coverage and the Stoxx 600 has widened to the detriment of the sector as oil and gas prices have come down and historic 2022 profits will not be repeated. We have, however, repetitively said that Oils have been through a regime change. It is no longer about volume but about value. The management of companies religiously implements this new mantra: forget growth, extract cash, pay out massively, and invest in the most lucrative upstream.
Source: AlphaValue
**This is just a summary of the full research. If you are interested to get access to the full research, valuations etc please contact us**
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