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REDUCTION FOR GROWTH

OPEC+ decision to extend oil production cut for another month helps maintain market balance

Author:

15.06.2020

The agreement signed by oil-producing countries to cut oil production and the gradual lift-off of the COVID-19 lockdown around the world had a positive effect on oil prices, pushing them above $40 per barrel for Brent. However, this was not enough to fully stabilise the market. There is still an imbalance between supply and demand, although the gap has narrowed. “Demand is recovering as large oil-consuming countries exit the lockdown. But the danger still remains, and we may have problems in the future,” Prince Abdulaziz bin Salman, Saudi Minister of Energy, said.

The ongoing tension between the US and China further exacerbates the situation. It has seriously worsened since Beijing decided to introduce its own national security law for Hong Kong.

The uncertainty regarding the lifting of quarantine measures in the world amid the fears of the second wave of COVID-19 also affects the traders.

Apparently, the OPEC+ decision adopted in June to extend the oil cut period for another month (9.7 mbpd) beyond the previously agreed deadline encouraged the oil market.

 

Building on success

On April 12, 2020, OPEC+ agreed to reduce oil production in three consecutive stages: in May-June by 9.7 mbpd, in July-December by 7.7 mbpd, and in January 2021 - April 2022 by 5.7 mbpd.

Following the ministerial meeting on June 6, OPEC and OPEC+ member states unanimously supported the extension of the first stage of cuts until the end of July. As expected, these actions should eventually balance the supply and demand in the hydrocarbon market.

“It was decided to extend the parameters applicable in May-June for another month, that is until July in order to strengthen the impact of the transaction and balance the market, to further reduce risks and uncertainties. So, instead of 7.7 mbpd in July, we agreed on 9.7 mbpd together with Mexico,” Russian Minister of Energy, Alexander Novak, said.

The remaining terms of the deal remained unchanged. According to the Russian minister, the existing trend will reduce huge reserves in the oil market, which in the spring grew by more than 1 billion barrels.

“I think this is the right decision. We have considered various options, and finally agreed that we would monitor the market situation on a monthly basis,” A. Novak said.

As part of the transaction, Russia and Saudi Arabia will be the major countries cutting oil production: 2.5 mbpd instead of the baseline level of 11 mbpd. According to the Russian minister, in May the level of fulfilment of obligations was quite high, with 9 mbpd removed from the market.

It is estimated that in July OPEC and OPEC+ countries will reduce oil production by 6.1 and 3.6 mbpd, respectively.

The market’s reaction to the new agreement was quite positive. On June 8, for the first time since March 6, Brent crude oil price reached $43.4 per barrel, and WTI futures came close to $40.

“Apparently, the need to extend a massive reduction period for another month or more suggests that, despite the recent rise in oil prices, large producers are still concerned about the fragile state of the oil market," AxiCorp's analyst Stephen Innes said.

 

Full compliance

The effectiveness of the new deal raises certain doubts, as not all parties abide by the terms of the deal in due manner. In May, for example, Iraq, Nigeria and Kazakhstan failed to fulfil their obligations.

That’s why all the parties agreed to fulfil all obligations of the deal in full and compensate for the volume of unfulfilled obligations. Otherwise, the agreement becomes void. Countries that have not fulfilled their obligations in May-June must compensate for production at the expense of the volumes produced in July, August and September.

“The oil demand began to recover due to the phased relaxation of quarantine measures and the partial recovery of the economy. We see the positive effect of joint actions to limit production. But it is important to note that the market is still fragile and needs support. Today it is important that all participants fulfil their obligations in full,” Novak said.

According to Mr. Novak, OPEC+ member states executed the deal by 90% in May. At the same time, Russia fulfilled it at the level of about 96% and expects to reach a 100% result in June.

Meanwhile, Prince Abdulaziz bin Salman was very categorical, saying that the OPEC+ countries would not tolerate violations. Such participants will have to compensate the volumes produced in June at any time in July, August or September. According to Salman, this means that the real level of reduction in August-September will be higher than in July.

According to analysts, the tightening of measures against countries that violate the terms of the deal, and the compensation of unreduced volumes in the next three months are a positive signal for the market, since they will accelerate the restoration of the balance of supply and demand.

In order to comply with fair, timely and fair execution of the transaction, the Joint Ministerial Committee (JMMC) was asked to monitor market conditions. So, the next JMMC meetings will take place monthly until December 2020. The next meeting is scheduled for June 18.

 

Azerbaijan cuts upfront

While Kazakhstan and Nigeria are preparing to reduce oil production, Azerbaijan began this process in May. Azerbaijan completed its homework over the past month by 98%, reducing production by 160.8 thousand bpd of the required 164 thousand bpd.

The daily oil production in Azerbaijan in May, excluding condensate, reached 557.2 thousand bpd, of which 437.6 thousand bpd was from the Azeri-Chirag-Guneshli field developed by SOCAR, as well as from the jointly operated onshore fields (119.6 thousand bpd).

“In May, Azerbaijan fulfilled the terms of the OPEC+ deal about 100%, which is a very good indicator. This is a great achievement. We failed to reduce the production only by 3,000 bpd,” Zamin Aliyev, adviser to the Minister of Energy and spokesman of the ministry, said.

At the same time, the Ministry of Energy assures that Azerbaijan is aimed at a 100 percent result and, possibly, will reach the necessary indicators in June.

By the way, Baku also supported the extension of the first phase of reduction until July. According to Minister of Energy, Perviz Shahbazov, the decision was made amid the crisis in the oil market and the imbalance between supply and demand.

At the same time, Mr. Shahbazov called on the parties to continue “a sensitive and flexible approach to regulating oil production until economic activity and balance in the oil market increase the demand for oil”. This most likely indicates that Azerbaijan is ready, if necessary, to provide the necessary support to the market in the future.

Remarkably, Goldman Sachs predicts a rapid drop in current oil prices, explaining this by the uncertainty of demand and the “frightening” reserves. The bank indicates that Brent is likely to cost $35 in the coming weeks. So the option of extending the deal for another month or longer cannot be ruled out, especially if the recovery of oil demand does not live up to expectations.

 

Extension OK?

Moscow was cautious about such a possibility. Minister Novak asked not to make premature forecasts, but to closely monitor the development of the market situation. “We have just adopted a decision for July and carefully studied the market situation. We seriously monitor the situation with demand of both air and automobile transport, as the situation expected in July-August will largely depend on this factor,” Novak said.

He believes that the extension of current OPEC+ quotas for August will depend on the market recovery, oil reserves and the fulfilment of obligations by all participant countries.

“In addition to the full execution of the agreement, the main condition is the current situation on the market and monitoring the speed of demand recovery and the situation in industries with existing demand. Of course, leftover reserves do also matter. Stocks over the past few months have increased significantly,” Novak stressed.

Russians have a similar position on the issue of changing the general terms of the OPEC+ transaction. “I think it’s too early to discuss the situation for the upcoming two years. The market is unpredictable, volatile, and depends on the global economic situation. We have already adopted a long term agreement: we started with 6 months, maximum 9, and now expect that the terms will be valid for the next two years. This is a signal to the market that for at least two years we will watch and take joint actions to balance the market. After that our actions will depend on the developing situation,” Novak said.

On the contrary, Riyadh does not exclude an increase in the terms of the OPEC+ deal until 2023. “OPEC+ member states remain vigilant about the market situation. In December 2021, we may adopt a decision to extend the terms until the end of 2022, which currently applicable until May 2022,” Abdulaziz bin Salman said.

Analysts believe that the extension of the deal for at least two or more months may increase the price of Brent to $40-45 per barrel.

The extension until August may not lead to a sharp jump in oil prices, but the agreement demonstrates the willingness of participants to respond flexibly and quickly to the worsening situation in the oil market, which is important. Now, when OPEC+ expects stable price increases, the final result depends on the parties and on their conscientious attitude to their obligations. Moreover, the refusal of a number of Middle Eastern countries to voluntarily reduce production in July in addition to the established quotas only adds to this responsibility.

The market has already responded to the warnings from Saudi Arabia, the UAE, Kuwait and Oman not to cut production by another 1.2 million bpd in July by lowering prices for oil. In this situation, non-compliance with the terms of the OPEC+ deal will only complicate the situation.

“The market was disappointed that Saudi Arabia decided not to cut production by another 1 mbpd in addition to the agreed quota,” ANZ experts say.

 

Shale oil industry recovers

According to AxiCorp, the main problem for OPEC+ is the possible recovery of shale oil production. Many American oil companies had to reduce or suspend shale oil production due to a collapse in prices.

WTI futures for May really showed record growth after April 20. For the first time in history, the contract value fell below zero. Over the first week of June, WTI price increased by 11%.

According to The Wall Street Journal, amid rising oil prices, US producers of shale oil began to partially restore production. For example, one of the largest independent oil producers in the United States, EOG Resources Inc., plans to restore production in 3Q2020. Parsley Energy Inc. recently announced to investors that it is already compensating for most of the decline in production in the Perm basin in western Texas, which amounted to approximately 26,000 bpd last month.

At the same time, WSJ notes that this increase will not be enough to achieve the record level of production of 13.1 mbpd recorded in March. According to the US Department of Energy, 11.2 mbpd of shale oil has been produced in the country by the end of May.

In addition, given that companies have suspended the drilling of new wells, we can expect that in 2020 the US production decreases, despite the increase this summer due to existing wells. The technology of shale oil production requires constant drilling of new wells, since the existing ones deplete rapidly. In the US, the number of drilling rigs in May decreased by 218 compared to the previous month (348). This is a record low.

According to EIA forecasts, oil production in 2020 will be lower by 100K bpd compared to the May forecast (11.6 mbpd), which is 0.7 mbpd less than in 2019. The forecast for 2021 has also been adjusted downward by 100K bpd, that is, to 10.8 mbpd.

In general, despite the current growth, shale oil production requires a higher price to recover. Dmitry Marinchenko, Senior Natural Resources and Commodity Group Director, Fitch believes that $50 a barrel or more is needed to bring shale oil production to sustainable growth.

According to the head of the Gazprombank Strategy Development Centre, Yegor Susin, the shale oil industry will recover if the price is between $40 and $50 per barrel. However, due to the heavy borrowing of a number of companies, much will depend on the amount of state support.

The gradual yet slow recovery in oil prices and demand obviously encourage all participants in the oil market, including the US. OPEC+ countries play an instrumental role in this process. It is not surprising that Washington welcomed the extension of the deal, because a steady rise in prices is what the American oil industry really needs. However, oil producers have a long way to go until they can relax. There will be no quick recovery. Plus, American oil is a serious threat to other market participants, who do not want to cut production and will certainly come up with a mechanism to limit the growth of production of shale oil companies.



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