Thursday 13, April 2017 by Jessica Combes

GCC Oil Sector Insights - BofA Merrill Lynch

 

Bank of America Merrill Lynch (the Bank) spent a week in the GCC, visiting Saudi Arabia, Bahrain, Kuwait, Doha, Oman, Abu Dhabi and Dubai, and meeting with economic policy makers, energy officials, political experts, diplomatic staff and representatives from government-related entities and the private sector.

The commodity team’s constructive base case view for oil prices suggest that tail risks may be fatter than anticipated. The market may be under-appreciating OPEC’s internal debates and scrutiny of shale oil production. A more flexible renewal of the deal for three months rather than six months is among proposals being examined. This  may be negatively perceived unless appropriately communicated to the market. The absence of an articulated post-deal exit strategy suggests that a return to a battle for market share when the agreement lapses is not to be fully excluded. The potential Aramco IPO could suggest incentives to support oil prices.

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The market disappointment with the outcome of the 2nd Joint OPEC/non-OPEC Ministerial Monitoring Committee (JMMC) that met in Kuwait on 25-26 March is not justified, in our view. The JMMC communique did refrain from recommending extending the agreement in May. However, the JMMC is not empowered to make recommendations and its main task is to monitor deal compliance. It consists of five oil producing countries (Kuwait, Venezuela, Algeria, Oman, and Russia) as compared to the 24 countries that are participating in the OPEC/non-OPEC November/December deal.

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Compliance is strong and appears to be improving. The JMMC reports that, as of February, OPEC and participating non-OPEC countries achieved a compliance level of 94 per cent, an increase of eight ppt over January. Compliance is likely to improve in March and April as Russian oil output falls further while UAE and Iraq have scheduled field maintenance. Some observers have questioned whether compliance could loosen in 2H17 due to seasonal increase in GCC domestic oil demand and to the potential completion of field maintenance in non-OPEC countries. The launch of the Wasit gas plant in Saudi Arabia may help displace crude burnt for power generation in the summer. In the meantime, the disruptions in the Libyan oil output may minimise the offsetting impact on the deal of rising production from exempted countries, such as Nigeria and Libya.

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It was found that energy officials guarded in their assessment of the likelihood of an extension of the OPEC/non-OPEC agreement at the next Ordinary meeting on 25 May in Vienna. The market, however, fully prices in an extension of the OPEC deal in May. An extension is also the Bank’s base case scenario. This is especially so as there is little time left until May for data to make a convincing case in either way. OPEC views its decision as critical and finely balancing several unknown factors. A renewal would require participation from non-OPEC countries, signs that the inventory correction is taking course and some assurance that the shale oil production rebound would remain contained. It was made clear during our meetings that OPEC was unlikely to renew the agreement if it came to the conclusion that the accords was setting it up for a course of permanently lower market share where it would subsidise shale oil production.

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As such, a renewal for a period of three months, rather than six months, is among proposals being examined, as it would allow monitoring and more flexible reaction to market developments. This may be negatively perceived unless appropriately communicated to the market, in our view. To this end, a six-month renewal may end up being favoured, particularly as this seems to be supported by Saudi Arabia.

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The next key catalyst date is on 21 April, as the Joint OPEC/non-OPEC Technical Committee (JTC) is to meet alongside the OPEC Secretariat to review oil market conditions. The JTC may proceed with recommendations to the JMMC and the Ministerial meeting taking place in Vienna at the 172nd Ordinary OPEC meeting.

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Our impression from our meetings is that OPEC views the lack of material adjustment in US inventories as mainly caused by low seasonal demand, refinery maintenance and the delayed impact of higher OPEC oil production in November and December. The latter is due contracted oil supply, which,  during that period will still be reflected in import arrivals in 1Q17 due to transit and transportation time. The refinery maintenance impact could be seen in the accompanying drawdown in oil product stocks. The end of the refinery maintenance season, the ongoing reduction in floating storage and the reduction in Saudi US oil exports support continued progress on market rebalancing.

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Our impression from our meetings is that OPEC would be comfortable with shale oil production growth of 300-400kbpd and would abandon the deal if production growth touches 800kbpd to one million bpd. The Bank currently forecasts US shale growth of 680kbpd in 2017 and 880kbpd in 2018, which is rapidly approaching OPEC’s tolerance levels. So far, the bulk of the increase in US oil production in 4Q16 was coming from already sanctioned production from the US Gulf of Mexico and not from US shale oil producers. OPEC’s target to push the crude oil curve into backwardation will help discourage forward selling.

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There are differing views within OPEC as to the exit strategy post-deal. As such, a return to a battle for market share when the agreement lapses should not be fully excluded at this stage. This could have negative implications for oil prices, depending on the prevailing demand and supply dynamics.

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Some observers suggested that a return to a quota system could be a natural extension of the current accord. This would be in line with the new five-year medium-term strategy document of OPEC, officially adopted in Vienna in November, which suggests that OPEC again sees its role as a more interventionist one. Such a quota system could be introduced to manage OPEC production and market share gains in a coordinated fashion going forward.

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Other observers doubted the timely conclusion of such quota negotiations or the feasibility of such as system, given the unknown production response from shale. They expressed the view that OPEC could instead be trusted to independently manage production appropriately. Failing that, OPEC observers suggested that price volatility may increase as the required market signal to discipline shale oil production.

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The recent CERA week speech from Saudi Minister of Energy, Industry and Mineral Resources Falih reiterated familiar themes of Saudi energy policy. His remarks suggested that Saudi Arabia may be surprised by the rapid shale oil production increase, but that it was open to rolling over the OPEC/non-OPEC deal in May. In regards to compliance, Saudi Arabia warned that it will not cut more than its target indefinitely. The concurrent self-reported increase in production in February may be interpreted as a signal in this direction. Saudi Arabia reported that it increased production in February to 10.011 million bpd, from 9.748 million bpd in January, compared to its production target of 10.058 million bpd. These production figures are self-reported and directly communicated to OPEC and JODI. OPEC’s secondary sources put Saudi Arabia’s oil production instead at 9.865 million bpd and 9.797 million bpd in January respectively. Saudi industry sources have explained the discrepancy between the two sets of data for February as being due to production being moved to storage to replenish stocks (after a decline for much of 2016), while underlying oil supply to the market was kept stable. Preliminary self-reported production figures suggest a modest reversal of the February production increase, bringing production marginally lower than 10 million bpd.

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Preparations for the potential partial listing of Saudi Aramco in 2H18 could provide an incentive for Saudi Arabia to continue its efforts to manage the market through coordination with other oil exporting countries. The potential lack of an OPEC exit strategy could likely require Saudi Arabia to act as a swing oil producer. Saudi Arabia could be willing to do so if its hypothetical market share loss to competitors would not be material. However, even if its market share stays protected, Saudi Arabia may again find itself unable to balance the market without broader participation from other oil producers, highlighting OPEC’s delicate ongoing balancing act.

  

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