In late 2016, the Organization of the Petroleum Exporting Countries (OPEC) agreed to its first production curbs in a decade and the first joint cuts with 11 non-OPEC producer nations, led by Russia, in 15 years (creating an OPEC+ assembly). The two sides decided to remove 1.8 million barrels per day (mmbpd) from the market in the first half of 2017 – equal to 2 percent of global production. The announcement was met with broad optimism from energy investors and a strong initial reaction in oil equities. Nevertheless, since the cuts were enacted at the beginning of 2017, skeptics have agonized about the impact to the global oil supply/demand picture once those cuts are ultimately removed. Even after the cuts were again extended with last November’s OPEC+ meeting, many pundits began to point to the group’s upcoming June gathering as possible inflection point for it to change course. By that time, OECD oil inventories are likely to approximate or will have reached OPEC+’s goal of the 5-year average, having drawn down much of the excess global inventories already. Moreover, inventories on a days of forward cover basis (often viewed as a more relevant metric since it includes demand) are already below the average and are likely to dwindle even further in 2018.

Still, we believe expecting an imminent change in OPEC policy is unwarranted and underestimates the group’s resolve, particularly that of its largest producing member, Saudi Arabia. There has been much speculation about the Kingdom naturally wanting to support oil prices ahead of the upcoming IPO of state-owed Saudi Aramaco. And, despite uncertainties regarding the timing of that offering (2H 2018 remains the target), we believe it is unlikely that Saudi will waver from its determination to complete the IPO, as well as to promote a healthy oil market surrounding the deal. Moreover, while Saudi’s oil operating breakevens may remain low (est $10-20/barrel), the oil price needed to pay for its expanded social programs and other increased government activities (e.g., military) is much higher (est. ~$70-$80/barrel). Prices well below such levels in recent years have led to a massive reduction in the Kingdom’s cash reserves from $746 billion at the end of 3Q 2014 to $485 billion as of 3Q 2017, providing much of the initiative behind the Saudi’s new economic diversity plan, Vision 2030.

Also, Saudi’s efforts have received major support from other key oil producing countries. This includes not only the traditional OPEC group, where compliance levels to the cuts are averaging well above 100% (a statistic aided by the massive decline in Venezuelan production). But, as mentioned above, it also includes an expanded list of non-OPEC countries, most importantly Russia, which says it may participate in the Saudi Aramco IPO. Interestingly, Saudi Aramco may also invest in Russia’s LNG-2 project, while Russia has made a formal offer to build two nuclear reactors in Saudi Arabia. We view this coordination as especially notable since the two countries have not been particularly fond of each other on the political front. Nevertheless, with Russia having its own economic challenges, it also has a high motivation for robust oil prices and therefore appears to have unwavering support of the production cuts.

All these factors indicate to us that OPEC is likely to seek reasons to maintain its current policy. One way of doing this would be moving the goalposts for production cuts. As Saudi Arabia Energy Minister Khalid Al-Falih recently told reporters at the Davos Economic Summit, the most recent five-year average “is overly weighted by three years of excessive inventory.” As such, we believe OPEC may change its target to the average inventory levels on an absolute basis in the 2010-2014 period. As shown in the chart below, this naturally implies further significant inventory draws to achieve that period’s 5-year average.

Finally, in surmising the threat from an eventual end of current OPEC+ policy, we believe it is often lost on investors that much of the 1.8 mmbpd in production cuts were essentially “fake cuts.” By analyzing the output from key producing countries, it is easy to see that production from several countries was artificially ramped into the cuts. This implies cuts from a baseline level considerably below the 1.8 mmbpd. Most importantly, OPEC+’s ability to fully bring back the 1.8 mmbpd should be limited by the Venezuelan situation (where oil volumes have dropped below 1.7mmpd, down nearly 700kbd since early 2016), but also with Iran already producing near full production capacity and with the risk of further supply disruptions in Nigeria and Libya.

At a minimum, the result should be a substantially reduced threat in both the timing and the amount of production returning to global supply. Moreover, we believe Saudi’s financial motivations and OPEC+’s potentially-lowered target for inventories could lead to a short-term over tightening in the market, resulting in further upside to oil prices. As Al-Falih told reporters last week in Riyadh, “If we have to overbalance the market a little bit, then so be it.”

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