As the global oil inventory surplus narrows and the goal of the OPEC cuts is within reach, the oil cartel is mulling a change in the way it defines success, with an eye on keeping the current production limits in place at least through to the end of this year.
Although there were a variety of reasons for oil prices rallying at the end of 2017 and hitting multiyear highs a month ago, the overarching reason was that the inventory overhang significantly narrowed, in large part because of the OPEC cuts.
The IEA says that OECD inventories are now only 52 million barres above the five-year average, a surplus that has shrunk dramatically from 264 million barrels a year ago. “With the surplus having shrunk so dramatically, the success of the output agreement might be close to hand,” the IEA wrote in its February Oil Market Report.
Other analysts have gone further. Citigroup and Goldman Sachs both estimate that the surplus has probably already been eliminated, meaning that the oil market has already reached the long-sought “balance” for which OPEC is aiming.
But as success draws near, oil prices are still not where OPEC wants them. The group is considering changing the way it measures “balance” in the market, for several reasons.
First, what constitutes the five-year average for inventories has changed significantly, with that period of time increasingly encompassing surplus years. The level of inventories that was “average” for the period of 2011-2015 is substantially lower than the “average” for 2013-2017 — the latter period includes more than three years in which the market suffered from a glut.
In other words, the five-year average inventory level is a moving target, and because it has been rising quite a bit, bringing global inventories down to that threshold is not as impressive as it would be if using an older five-year period.
As a result, Saudi oil minister Khalid al-Falih suggested that OPEC would meet to discuss using a different metric. One option would be to use the “forward demand cover,” Bloomberg reports, or the number of days that the current stock of inventories could supply the global market. This would arguably be a more accurate measurement because it would incorporate the fact that demand has climbed significantly in recent years.
That metric would probably work better as a barometer for oil market health, but as Bloomberg notes, by that measure, the oil market is still probably close to, or already at, the rebalancing point. The IEA said that as of December, OECD stocks were equivalent to 60.6 days’ worth of supply, which is back at the five-year average. OPEC will probably need a different metric if it wants to justify keeping the cuts in place.
The problem for OPEC — and al-Falih admitted as much — is that the world is only going off of data from the OECD. There isn’t a ton of accurate or transparent data from much of the non-OECD. Citi incorporated several non-OECD nations into its estimate, including Saudi Arabia and Brazil, and it still concluded that inventories are back to the five-year average.
Regardless of the evidence, OPEC hopes to keep the production curbs in place through the rest of the year at least. “If we have to overbalance the market a little bit, then so be it,” al-Falih told reporters last week. “Rather than quitting too early and finding out we were dealing with less reliable information,” he said. It’s better to “stay the course and make sure that inventories are where the industry needs them.”
Much of the motivation for al-Falih is to keep the Saudi Aramco IPO on track. But for that to occur, Saudi officials feel they need oil prices to be closer to $70 per barrel than $60. And, crucially, that price level of $70 needs to be in place in a year or two, not just today.
As a result, as Reuters notes, rather than simply looking at spot prices today, Saudi officials are probably watching oil futures dated 1 and 2 years out. “When will the ideal moment come?” an unnamed OPEC official told Reuters. “Maybe you should also look at the forward curve for oil … as the forward curve will be key for investors valuing Aramco.”
In that sense, the Aramco IPO is, in a way, driving OPEC policy. But because oil futures for March 2019 are just above $60 per barrel — and 2020 futures are a few dollars lower — Saudi officials are pushing hard to keep the production limits in place for a while longer, hoping to drive up prices. “If you’re Mohammed Bin Salman, and trying to radically reinvent your country” then “you need a certain price to make it work,” said Helima Croft, head of commodity strategy at RBC Capital Markets LLC, according to Bloomberg.
As a result, the OPEC cuts could remain in place, regardless of whether or not global inventories are back at the five-year average. Whether or not it is explicitly stated, Saudi officials could be pushing to keep the OPEC limits in place until futures prices rise to $70.
By Nick Cunningham of Oilprice.com
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