OPEC Deal Impresses, But Implementation Will Be Key to Prices

by Greg Sharenow of PIMCO, 12/8/16

At its 30 November meeting in Vienna, OPEC producers agreed to a deal on production cuts that exceeded consensus expectations (as well as our own) and led to a 15% rally in prices over the following three days.

While the deal has clearly been positive for the oil markets, we’re keeping a close eye on implementation. A production target of 32.5 million barrels per day (b/d) will go into effect on 1 January 2017 and last six months, implying a cut of 1.2 million–1.4 million b/d (depending on the chosen baseline), with the caveat that Nigeria, Libya and Indonesia are unrestricted. OPEC also indicated that non-OPEC producers, led by Russia and Oman, will be cutting another 600,000 b/d.

Five things we’re watching after Vienna

We believe the impact on balances and prices (see our forecasts below) ultimately will depend on five key variables:

Compliance within OPEC, which, as former Saudi Arabian oil minister Ali bin Ibrahim Al-Naimi noted after the deal was announced, can be quite poor
Whether non-OPEC producers contribute additional cuts above and beyond what was already expected due to underinvestment (e.g., any cut that includes Mexican production should be discounted)
How much output the U.S. and other “short cycle” producers bring online, given that higher prices will send investment signals
Whether higher prices dampen future demand growth, given solid year-over-year price gains, particularly when denominated in most non-U.S. dollar currencies
Whether OPEC producers ramp up output at the end of the deal’s term to meet peak summer demand and refinery requirements, reducing the ultimate market impact

These caveats are not meant to downplay the importance of the deal, but rather to highlight the uncertainties related to production estimates and the agreement’s actual execution. To gauge compliance, we’ll be watching producers’ actual loading schedules and physical loadings with keen interest, given that the Official Selling Prices from Saudi Arabia were not particularly discouraging for refiners. However, even these indicators will offer an incomplete picture, given that internal inventories could be building (rather than actual output being cut).

Our production and pricing forecasts

We assume relatively good implementation of the deal and have reduced our production forecast for the first half of next year to 33.0 million b/d, a few hundred thousand b/d below our expectations before the September Algeria meeting but still up year-over-year. We are leaving our second-half 2017 OPEC production outlook unchanged at 33.4 million b/d but believe this could prove conservative. Accelerating U.S. production as investment picks up also skews our outlook for second-half 2017 output higher. Our first-half 2017 forecast of 10.8 million b/d for Russia is unchanged, but we believe this could prove too low given that Russia’s output has accelerated significantly above our baseline in recent months and the country agreed to only “gradually” cut 300,000 b/d.

As for pricing, we see modest upside to our 2017 forecast for prices in the low- to mid-$50s, particularly if implementation of the deal exceeds expectations. At the very least, we think the deal greatly reduces downside risk to prices. In addition, a reduction in the storage surplus should mitigate the contango in the market (and resulting negative roll yield to investors) and could spur an increase in investor interest.

All told, we’re watching how the deal unfolds with cautious optimism for prices.

Greg Sharenow is a PIMCO portfolio manager focusing on real assets and is a frequent contributor to the PIMCO Blog.

OPEC Deal Impresses, But Implementation Will Be Key to Prices

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