Let’s just be clear about something: OPEC doesn’t have to do a thing about falling crude prices if they don’t want to.
This idea that Riyadh is in the middle of a fiscal crisis is a popular delusion. Sure, GCC budgets have seen better days, but if you think a bunch of basically insolvent (depending on the environment) shale operators can wait out the Saudis, well then by all means place your bets but I think that’s a profoundly ridiculous notion.
“OPEC itself can let prices sink [and] now may be the most opportune time to let U.S. tight oil producers self-destruct,” FGE Chairman Fereidun Fesharaki wrote earlier this week, adding that “if the Saudis maintain production at 10m b/d prices will decline to $30- $35/bbl.”
They could, Fesharaki went on to write, “let the price sink and not rescue the market until 2019 at the earliest, postpone the Aramco IPO and swallow the pain.”
Obviously, that would be a tough pill to swallow for OPEC economies, but they could choke it down.
If, however, they’re serious about making the cuts work, it could be that they have to go the George Bush route. Because as Goldman notes, the cartel is still the cartel and if they really wanted to, they could introduce “shock and awe.” Here’s more…
OPEC can influence the outcome with a “shock and awe” cut and a bearish guidance
Our confidence that Libya and Nigeria production will be sustainable at 3-year highs remains low; however, such a recovery would offset most of the draws we expect in 3Q17. This leaves OPEC’s response key to the rebalancing process. We continue to believe that OPEC’s decision to cut production last year was sound, as it made sense to cut for a short period of time to accelerate the upcoming inventory draws. In hindsight, it is the implementation of the cut that was flawed given (1) the timing of the announcement, during US E&Ps budgeting season, (2) the late 2016/early 2017 export ramp-up, (3) the shallow and long-duration nature of the cuts, creating a misleading assurance that OPEC would support prices at $45/bbl, and (4) the lack of a credible exit strategy after the cuts, with vague assurances of extending the cuts next year.
The approach adopted so far by OPEC, akin to that of a central bank, has ultimately proved self-defeating by cutting too little but reassuring too much.
As a result, not only were shale producers investing on overly optimistic price expectations, they were doing so on a truncated perception of price distribution, distorting their assessment of the real option value of their drilling. This suggests that OPEC’s next step should be more forceful but less visible.
Specifically, we believe OPEC still has the opportunity to make their strategy work by explicitly guiding to higher production next year (or by selling long-dated futures) and by implementing a larger cut in the short term. Such a cut should be well in excess of the potential increases in Libya and Nigeria production, with little communication needed around it as declining inventories will be the only measure of its success. Despite our expectation that OPEC’s long-term incentive is to grow production strongly, we believe that such a “shock and awe” last cut is preferable from a fiscal revenue perspective to abandoning the cuts and ramping up sharply. The current high level of shale activity would further likely prevent US producers from ramping up significantly more and once again replacing all the barrels OPEC removes from the market. Shale will, however, over time be able to catch up, and hence this cut strategy can only be transient.