Failure of OPEC+ to deepen cuts may drive oil to $40, says report

New outlook by international observers has shown that a substantial build of global crude stocks and a corresponding drop in oil prices is imminent if additional oil production cuts by OPEC in 2020, is not followed by OPEC+.

Empirical evidence has demonstrated that a 1 million bpd surplus of oil can be expected to cause an oil price decline of around 5% per month, implying a potential drop of 30% over six months.

According to Rystad Energy’s estimates, the global oil market will be fundamentally oversupplied to the tune of 0.8 million barrels per day (bpd) in the first half of 2020.

While the Minister of State for Petroleum Resources, Timipre Sylva has assured OPEC of compliance to cuts, there are concerns for the implementation of the 2020 budget if oil prices fall below proposed benchmark.

In the proposed 2020 budget, the Federal Government estimated oil sales to stand at 2.18 million bpd at a price of $57 per barrel, while the exchange rate is expected to remain N305 per dollar.

“We have a clear message to the OPEC+ countries: A ‘roll-over’ of the current production agreement is not enough to preserve a balanced market and ensure a stable oil price environment in 2020,” says Bjørnar Tonhaugen, head of oil market research at Rystad Energy. “The outlook will be bleak if OPEC+ fails to agree on additional cuts.”

“If OPEC and Russia don’t extend and deepen their cuts, we could see Brent Blend dip to the $40s next year for a shorter period,” Tonhaugen said.

“In order to ensure a balanced market, our research indicates that OPEC would need to reduce crude production to 28.9 million bpd – a drop of 0.8 million bpd from the level seen in the fourth quarter of 2019-levels – given our forecast for demand, non-OPEC supply and the impact of new IMO 2020 regulations on global crude runs,” Tonhaugen added.

New shipping fuel regulations, the so-called IMO 2020 effect, are expected to create more demand for crude oil in the near-term. However, if the actual effect of the IMO rules on crude demand turns out to be zero the “call on OPEC” – the amount of OPEC oil needed to meet demand – drops by 1.9 million bpd year-on-year to 28.3 million bpd.

“Despite decent cut compliance from the group as a whole and large involuntary declines in Iran and Venezuela this year, OPEC’s current crude production of about 29.7 million bpd is far above the ‘call’ for 2020. Alas, without deeper cuts taking effect in January 2020, large global implied stock builds are on the cards,” Tonhaugen remarked.

Rystad Energy sees three alternative OPEC+ decision scenarios: “Base case: Extension of current production cuts to June 2020. Global oil market will be oversupplied to the tune of 1.2 million bpd in 2020. Significant oil price correction, possibly down to the low $40s for a short period, is likely.

“Deeper cuts: Additional cut of 0.75 million bpd on top of the 0.3 million bpd in the extension scenario would reduce the supply overhang and ensure stable prices.

“No deal/market share war: A ramp-up to maximum production capacity in all countries could have devastating effects. With potential stock builds of 2.3 million bpd, oil prices could fall below $30/bbl – lower than during the previous lows of 2016. Such a scenario would be devastating for the forward curve structure as potential stock builds would be larger than what we have observed historically”.

Rystad Energy finds that OPEC+ as a whole has cut oil production by 2.6 million bpd year-to-date, compared to October 2018 reference levels and the cut target of approximately 1.2 million bpd. The additional 1.4 million bpd of “cuts” are owed entirely to involuntary declines from Iran and Venezuela, both of which are exempt from the agreement. Saudi Arabia has led the group’s compliance by cutting 870,000 bpd in 2019, or 2.7 times its target cut of 322,000 bpd.

“Saudi Arabia has signaled that it seeks stricter compliance by other producers and is no longer willing to shoulder the burden of sub-compliance by others, such as Russia, Iraq and Kazakhstan, which have all failed to reach 100% compliance with their target cuts,” Tonhaugen said.

The challenge for OPEC+ is the strong supply growth elsewhere in the world. Rystad Energy forecasts a supply growth of 2.6 million bpd year-on-year in 2020, led by US shale, Norway and Brazil against weak global demand growth of only 1.0 million bpd year-on-year. Rystad Energy forecasts that non-OPEC non-US supply will grow 1.2 million bpd year-on-year in 2020, OPEC estimates this number at 0.6 million bpd year-on-year.