Yesterday’s OPEC outline agreement to reduce production has surprised the market, as recent OPEC gatherings had failed to generate alignment at a time of high regional tensions. We believe comments running up to the meeting, and yesterday’s statement do indicate a change in Saudi policy.
We see any agreement between Iran and Saudi in the current environment, particularly with Russia’s involvement, as historic and a more positive signal for the region. The resulting, relatively muted, oil price move does however signal that the oil market remains sceptical that the outline deal will result in a material impact to OPEC production.
We would take a slightly different viewpoint, particularly given recent developments with the oil market fundamentals: data is suggesting inventories are finally falling in the United States, and a lack of available spare production capacity globally. Our analysis demonstrates that, at this stage, even modest reductions in OPEC production would lead to a relatively swift reduction in inventories, and a necessity for oil prices to move back towards $60/b to stimulate sufficient investment activity to balance the market in future years.
There is a significant risk that the outline deal does not transition into structured cuts and this would be negative for sentiment. However the fact that OPEC members have come this far suggests that the main producers are struggling to maintain investment at recent oil price levels and are producing at close to maximum, and in some cases at rates that they are uncomfortable sustaining. Indeed we have seen Saudi domestic crude inventories falling since last October, and Iranian headline rates have also been bolstered by reductions in storage. Targets for sustaining Iranian production at over 4 mb/d looked stretched, given historic production rates and the lack of recent investment. Growth from Iraq had also plateaued with reduced investment.
We note that many of the objectives of recent Saudi policy have been achieved, though at some pain to the Saudi economy. US production has fallen 1 mb/d from peak levels, and approximately $1 trillion of investment has been cut. Maintaining low oil prices was becoming self-defeating as the US shale industry is adapting. Saudi policy makers have demonstrated internally the need to diversify the economy, however achieving the Saudi “Vision 2030” plan requires a higher oil price; as the catalyst is the sale of a Saudi Aramco stake, which is price dependent.
We therefore believe, at the very least, yesterday’s OPEC move puts a higher floor under the oil price. Our modelling suggests that the $1 trillion capital withdrawal from the sector will have a significant ongoing impact on production levels. General sentiment towards the sector has been extremely reticent, with significant fears over the future demand impacts of electric vehicles. Our, and other studies demonstrate that, even with the most aggressive adoption of electric vehicles, oil demand will continue to increase for at least a decade. We believe that OPEC is cognisant that should oil prices do not recover relatively quickly to $60/b, investment levels will be insufficient to balance the market, creating price spikes that will ultimately be detrimental for oil demand.
We are excited for the outlook for energy investors. We have seen very meaningful moves in corporate strategies, particularly amongst the large oil companies. Finally corporates are addressing cost structures and capital investment efficiency. Improving the return on capital has replaced production growth as the main corporate goal, allowing the industry to sustain higher distributions. Improving oil prices, and some confidence in OPEC strategy, makes the sector a very compelling investment within a wider market that is struggling for momentum. We are maintaining our progressive oil price call, and have positioned our strategies to benefit strongly from improving oil prices.
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