OPEC's role in midst of shale strength

By Christopher Sell on 9/25/2017

LONDON (Bloomberg) -- Bassam Fattouh, director of the Oxford Institute for Energy Studies, argues that while U.S. shale poses a threat to OPEC, the idea that the organization has no role in the oil market is unrealistic. Fattouh was interviewed via email between Sept. 21-22. Comments have been edited and condensed.

Can OPEC still manage the market given shale’s strength?

There is no doubt that the context within which OPEC is operating has dramatically changed. Within OPEC, the output from some producers such as Nigeria and Libya has become more uncertain. The re-entry of Iraq with its massive reserve base, low production cost and ambitious plans to increase its productive capacity, and Iran’s plans to increase productive capacity after the lifting of sanctions, will complicate the management of OPEC output.

Outside OPEC, U.S. shale and its short-term investment cycle is creating additional challenges for OPEC. But, this does not mean that OPEC has no role in this context. The idea that U.S. shale can do it all at any cost -- at least at $50/bbl -- is over exaggerated and even at current prices, their business model remain challenged with overall free cash flow in the sector remaining negative.

However, to stay relevant, OPEC certainly needs to adapt its strategy. In addition to putting a floor on the oil price, OPEC should be proactive on the upside and put a ceiling on the oil price. OPEC needs to continuously test the ceiling to maximize revenues. However, this requires new ways of thinking, and developing a new set of tools and more effective communication strategy.

Will there be an extension cut agreement in Vienna?

The market is currently showing strong signs of rebalancing, in part due to OPEC cuts, but also due to strong oil demand.

Most of the rebalancing has been reflected in the strengthening of the time spreads and differentials. It is only recently that price levels started catching up. I guess OPEC will be closely monitoring the market balances and the market sentiment between now and the next OPEC meeting before making any decision.

What the market is concerned about the most is what happens after the expiry of the deal -- whether this will be in March next year or later in 2018. There is a perception in the market that once the deal expires, producers will enter into another market-share war, flooding the market again. I don’t consider this scenario to be the central one. After all, all producers have an interest in an orderly exit.

Also, the one country that can make a real difference in terms of global balances is Saudi Arabia. For multiple reasons -- some to do with the domestic economy and some to do with relations with other producers -- I don’t see Saudi Arabia putting the market rebalancing at risk, especially after all the efforts made in the last few month. Otherwise, why shift strategy from market share in the first place?

How can countries be encouraged to meet cut commitments?

It is important to put the current cuts in a historical context. The compliance has been strong so far compared with previous agreements. Of course, for those producers who are fully complying, it is always frustrating when their fellow members don’t fully abide by their quotas and are seen to be gaining share in key markets at their expense.

But, these frustrations should be managed behind closed doors and these behind-door discussions sometimes work, as recent experience with the U.A.E. and Iraq shows. In a fragile environment where sentiment is bearish, key producers should not create doubts about the agreement or give the impression that they are willing to shift strategy as a result of free-riding by other producers. Such signals will only reinforce the bearish sentiment.

How damaging is the spat between GCC members and Qatar?

The impact of the ongoing spat has been muted on oil and gas markets so far. Also, it did not affect the dynamics within OPEC.

But, even if Qatar were to leave OPEC -- and I do not expect this will happen -- the country produces around 0.6 million barrels a day, with its output on a sustained downtrend since 2008. It has no new oil projects in the pipeline and in this current price environment, there is very little investment being carried out to reverse the declines. So, Qatar is not in any position to raise production beyond the 10,000 to 20,000 barrels a day it has cut since January, which would hardly affect global balances.

However, on the demand side, Qatar’s overall domestic oil demand, particularly jet fuel demand, is expected to weaken as the embargo by its neighbors hit hard key sectors of the economy such as airlines and tourism. Qatar’s demand is quite small to have a big impact on global balances, though at a regional level and for some products such as jet fuel, the impact will be felt as Qatar’s demand for jet fuel accounts for a considerable share of Middle East demand.

More importantly, the prospects of greater economic cooperation in the GCC looks bleak as trust has been broken, with negative long-term economic consequences for Qatar and the rest of the GCC. Common initiatives such as introducing indirect VAT and strengthening trade, capital and labor flows to promote regional growth and diversification are now in doubt.

Will the shift in demand affect pricing strategies?

There is no indication so far that Saudi Arabia is willing to abandon this current system, despite some market concerns about the effectiveness of the Dubai Platts window in discovering prices. Given that most of the growth is originating from Asia, Saudi Arabia will always make sure that their crude remains competitive there.

But, there is no doubt that competition has intensified as more exporters divert their crude to Asia. Therefore, all producers are exploring ways to market their oil more effectively. Also, the refining scene in Asia has become more sophisticated and refineries can source crude from any part in the world. In the longer term, there is a belief that acquiring downstream assets can secure market for their crude, but the effectiveness of this strategy needs yet to be proven.

How much attention are you paying to Trump’s rhetoric on Iran?

Last year, many observers doubted whether OPEC would reach an agreement, pointing to the tensed relations between Iran and Saudi Arabia. But this is less of an issue now. Iran’s upside potential from here is limited, especially now that floating storage has been emptied. To increase capacity, the country needs to attract foreign direct investment and technical expertise and this will take time.

I can’t see why OPEC would be delighted if sanctions on Iran are slapped back. This will create unnecessary tensions, which OPEC can do without.


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