Where is the Problem with the OPEC & NON-OPEC Oil Production Cuts!
A Different Perspective!
The question that is still keeping oil market analysts and players confused is: Why is global oil supply still outstripping demand despite OPEC/non-OPEC production cuts of close to 1.8 million barrels a day from January 2017!
Despite the historical levels of compliance in the reductions by OPEC and Non-OPEC producers , the market is still seen by many as awash with oil due to the continued increase in new forms of oil supply, especially with the recovery of production in a number of countries as their geopolitical conditions improved over the past weeks.
Some analysts and media reports attribute such imbalance to the fact that the wrong types of were cut from the oil markets! This so-called imbalance in production cuts from their point of view was because the production adjustments were not carefully studied and not orchestrated carefully. Medium/Heavy Sour Crudes took the biggest hit in the share of the production cuts, and therefore there are now excess quantities of available light unwanted crude oil with low refining margins incentives and profitability for sophisticated refineries, which could lead to the accumulation of floating storages in very large crude carriers (super-tankers) to be filled again.
While it may be conceivable that some media reports and analysts are projecting the failure of OPEC & Non-OPEC’s efforts to re-balance oil markets through consistently presenting bearish data such as the high figures for the levels of floating oil storages, which some claim to be the highest in seven years; although their levels are very close to levels from recent months; without realizing and explaining that the main reason behind the economic feasibility of chartering tankers for floating storage use is actually the OPEC & Non-OPEC agreement itself which reduced oil production, hence creating a surplus of ships and a reduction in shipping rates which led to the recurrence of the floating tankers phenomenon.
This is one of many misunderstandings of the fundamentals and dynamics of the oil markets which I hope to clarify through 5 main points:
The forward curve for the Benchmark crudes NYMEX and ICE Brent are still in the Contango structure, which means higher future prices than current prices, signaling an ongoing weakness in the prompt months due to oversupply, while Dubai price structure already shifted to Backwardation, with lower future prices than current prices. This proves that the oversupply oil markets is linked to the sweet crudes linked to Nymex and Brent, and not to the sour crudes linked to Dubai! Hence, it's uneconomical to store sour crude that is linked to Dubai since the future prices are lower than the current prices. That being said, the majority of OPEC production is sour crude from the Arabian Gulf countries that won't store their crude oil in floating storages.
As shown in the attachment, the imbalance in the supply and demand is attributed to the current crude composition of the increase in supply outside the production of OPEC countries from the majority of the Light / Sweet crudes with very low sulfur content (less than 0.5%). This increase in supply is at the expense of the Medium/Heavy crudes with high sulfur content (higher than 0.5%), which is represented by the majority production from OPEC countries as shown in the OPEC Basket Crudes specifications average of the specific API gravity and sulfur content except West African light sweet from OPEC members production!
The OPEC & Non-OPEC cut agreement did not impose a reduction in certain type of oil (though it is an impossible mechanism to apply); it is up to individual nations to determine which crude oil quality they want to reduce production of. It is contractually prohibited for most of the Arabian Gulf Crudes to be freely traded in the SPOT market and thus to be stored in floating storages (tankers). The Crude Oil Sales Term Agreement for the Arabian Grades is with end users only (direct refineries and consumers). There are a few exceptions amongst some OPEC member countries which allow their crudes to be freely traded; most notably West African sweet grades are traded in the SPOT market and linked to Brent pricing that are mostly accumulated in floating storage.
The Asian oil market suffers from oversupplies of light sweet crude oil with low sulfur content, and this situation is exacerbated by large inflows of the open arbitrage from North Sea, West African crudes, and even with some US Shale Oil. The sudden increase in floating tankers took advantage of the narrowing Brent/Dubai Spread, which prompted the North Sea and West Africa to sail eastward to Asia and the Pacific markets. This proves that there are very large quantities of West African oil that sailed eastward to Asia in recent months! The difference between Brent and Dubai is becoming very narrow, which makes it economical to sell North Sea and West African Brent Linked crudes in the Asian market that is linked to Dubai prices.
With the narrowing of the Brent / Dubai price spread and the narrowing spread between Light/Heavy crude grades in general, Medium and Heavy crude grades are relatively expensive for the Asian refineries, although most of the new sophisticated refineries in the Asian markets have been designed to process heavier crude slates in order to take advantage of its lower prices compared to light sweet typically more expensive crudes. Nevertheless, we see the refining margins of medium and heavy grades in Asian markets have improved significantly.
Therefore the success of the OPEC & Non-OPEC cuts can be measured in the short term and the medium to longer term in several ways:
- - The evolution of a robust and solid cooperation for the first time between OPEC and several key Non-OPEC producers; most notably Russia. This is the first milestone in the road to cementing a solid long lasting cooperation framework between OPEC and Non-OPEC producers; this may be extended to include other Non-OPEC producers in the future. Producers who will not control their growth will stand to lose on the long run.
- - The significant rise in the absolute level of oil prices by more than US$ 12 per barrel when comparing the price of Brent for Jan-June 2016 to Jan-June 2017. This with doubt represents a significant addition of value to the national economies of the nations involved. There is no doubt that without these cuts in production prices would have dropped to much lower levels than current levels.
- - The unprecedented level of trust and cooperation that has emerged will benefit these nations who agreed and signed the declaration of cooperation and will surely extend to means of boosting cooperation on a bilateral level between many of the countries involved.
In the absence of a truly detailed understanding of the oil markets intricate details, and based on purely speculative and theoretical knowledge one cannot criticize such successful mechanism, implementation nor the results achieved thus far of production cuts by OPEC and NON-OPEC, especially in relation to the cuts as being disproportionately high in medium and heavy at the expense of maintaining the high supply of light oil grades, and especially in the most important oil markets in the world!
Dr. Faisal Mrza
Energy & Oil Marketing Adviser (Former OPEC / Saudi Aramco)
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.