Here Are The Three Choices Facing OPEC Next Week

The last time OPEC (and Non-OPEC) member nations sat down to attempt a coordinated increase in oil prices by cutting production they succeeded... for about three months. Every since then, oil has been on a gradual declining path, boosted by a surge in US shale output and declining global demand, with WTI recently even sliding sliding below OPEC's implicit price floor of $50/barrel. Which is why on May 25, after the failure of the first 6 month production cut, the same nations will try the same exercise, this time looking to cut output for 9 months, and hoping for a different outcome.

At least that is the general expectation. BofA's Francisco Blanch has released a note previewing next week's OPEC meeting titled "OPEC: extend and pretend", and which boils down to the 3 choices faced by OPEC: maintain, curb, or hike output. For its part, BofA believes that OPEC will extend cuts and hope demand recovers. Additionally, Blanch also states that OPEC’s goal for the oil market is to reach backwardation, not a specific price level and does not believe that OPEC will proceed with deeper cuts as this would likely mean ceding more market share to U.S. shale production.

As Blanch explains in the summary, the global oil market deficit is smaller than the bank thought (see the dramatic, 500kb/d downward revision to global demand growth in chart 2 below) and as a result the cartel is struggling to bring down global stocks. This situation presents a major challenge for the cartel, as OPEC is targeting a shift in the term structure of global crude markets and not a specific oil price band according to Blanch: the idea is to penalize forward sellers and squeeze refiners. But soft demand in India and Mexico, a warm US winter, and an OPEC crude oil production overhang from 4Q16 have gotten in the way of a good plan.  

Which brings up a question that has been floated by some (including this site) in recent days: "Why not cut further?"

 Well, according to BofA, if OPEC cuts production even more, it will likely lose additional market share to US shale and prices may not move up much more. Conversely, if OPEC hikes output, oil prices could collapse to $35/bbl, setting the cartel on an even more difficult fiscal path. In our view, most OPEC members can not afford either scenario at this point. With many member countries already experiencing large government and current account deficits at current oil prices, neither lower prices nor a permanent loss in output are appealing options.

As a result, BofA is confident OPEC will stay the course, keeping production on hold over 6 to 9 months and hoping that demand improves.

Below are some some select excerpts fromthe BofA note:

Putting it all together, BofA says that heading into the May 25 meeting, the cartel basically faces three choices.

1. First, OPEC could cut production beyond the 1.2mn b/d agreed in December and encourage non-OPEC members to deepen the cuts.
2. Second, OPEC could increase output aggressively and restart the oil price war.
3. And third, OPEC could keep the cuts at the current levels for the next 6 to 9 months and hope for oil market demand conditions to improve.

What will OPEC do? According to BofA, "the cartel will extend the cuts and pretend everything is fine." Which likely means that as oil prices fail to rebound, next March it will be same time, same place for OPEC which will again be scrambling to find some solution to a world in which it is no longer the marginal price setter.