The OPEC "Vienna Matrix" - If 1MM Cut, Oil To $59; If No Cut, Oil To $40

While the market has taken the latest round of "optimistic" jawboning by OPEC members in stride, sending crude higher by 4% ahead of next week's OPEC meeting in Vienna where the terms of the OPEC production cut are expected to be finalized, the reality is that a favorable outcome may be problematic.

As Bloomberg's Julian Lee explained overnight, "OPEC says it’s close to a deal to cut oil output for the first time since 2008, a move that may halt a 2 1/2-year price slump. The actions of individual member states tell a different story. The simple math supporting cuts looked solid at OPEC’s meetings in June and December. Prices then were way below most members’ fiscal break-even points. An output cut now of 1.5 million barrels a day, or 5 percent, would need to boost the oil price by only $2.50 a barrel for OPEC nations collectively to be better off. A $5 price increase would boost the value of what they pump by about $100 million a day."

There are various nuances as to why a deal, one in which Saudi Arabia would bear the brunt of total production cuts, but as Lee notes, while OPEC Secretary-General Mohammed Barkindo has been touring member nations to shore up support for an agreement before the Nov. 30 meeting, culminating with a trip to Doha for talks last week, "the meeting didn’t resolve much. It certainly didn’t tackle any of the thorniest questions that OPEC must still overcome if coordinated measures are to happen."

“The road from the OPEC agreement in Algiers to the next official OPEC meeting in Vienna is long and bumpy,” said Harry Tchilinguirian, head of commodities strategy at BNP Paribas SA in London.

Meanwhile, OPEC production continues to surge, hitting new all time highes just this month, effectively leaving the cartel little option but to reduct supply, however even with a cut it would only bring down production to a level seen as recently as May of this year. As a result, as Bank of America notes, downward oil price pressures are now coming mostly from within the cartel itself. "Will OPEC decide to end the price war or not? For starters, it is important to note that the cartel is running with very limited spare production capacity. As a result, we would argue that it makes good economic sense to end the price war, or at least declare a truce, at this stage."

Which brings us to the 4 possible outcomes from the Vienna meeting and how they would impact the price of oil.  Here is how Bank of America lays out the possibilities:

• First, we see only a slim chance that OPEC does not announce an oil supply cut deal on November 30, an outcome that could send oil prices temporarily below $40/bbl, in our view.
• Most likely, OPEC will go with a 500 thousand b/d or 1 million b/d supply cut announcement, in our view. Should OPEC just deliver a half a million barrel deal, we see prices staying around the current levels.
• For prices to firmly break over $50/bbl, OPEC would have to deliver a 1 mn b/d cut.
• If the cut comes with firm quotas and a tight control mechanism, we see WTI prices averaging $59/bbl in 2017, while a looser deal would probably shave $5 off this number.

Some more detail on the two most likely outcomes:

OPEC agrees to 1 million cut:

Historically, Saudi production has fluctuated quite extensively to follow price (or demand) trends (Chart 15), in turn allowing for a steady and well managed inventory cycle. While BofA is not expecting a return to the old regime where Saudi micromanaged global oil stocks, it does project OPEC crude supply to drop sequentially (Chart 16). Under this scenario, BofA's base case, WTI crude oil prices will average $55/bbl in 1H17 and $59/bbl over the course of the year. The cut would enable a fast rebalancing of global crude markets and possibly a shift into backwardation. Moreover, the deal would likely incorporate a production freeze from Russia.

Oil may drop to $40/bbl if the cartel cannot agree to cut:

A 1million b/d swing in global oil supplies impacts prices, on average, by about $17/bbl (Chart 19). With non-OPEC supply stabilizing and OPEC adding more barrels to the market in recent months, a price recovery is looking less likely. If OPEC does not come to a deal on supply, we see the oil market surplus extending through 3Q17 (Chart 20) and oil prices facing a renewed slump. In some ways it is OPEC's moment of truth, or maybe just a moment of truce. After all, the ongoing price war is driven by technology. Even if the cartel puts a 12 month supply cut deal together, technological advances will likely keep pressing down shale oil cost structures.