Recent statements by analysts at Credit Suisse reveal why the upcoming OPEC meeting is not only the most important day for oil in 2016, but likely since 2014 when OPEC decided to pursue a strategy of increasing production and expanding market share. Credit Suisse stated that a successful set of cuts could send oil to US$60/bbl, while no deal (or a weak deal) could send prices back to US$35/bbl.
What would be considered a success? Back in September, OPEC produced a target production range: 32.5-33 million bpd. In August 2016, OPEC produced 33.2 million bpd, but since then OPEC has ramped its production up to record levels, producing 33.64 million bpd in October. The market will likely be looking for a firm cut to 33.5 million bpd (or lower) as a sign of a successful agreement.
This means OPEC now needs to come up with 1.1 million bpd of production cuts to please the market. At this point, the odds of some sort of deal looks likely. Saudi Arabia (OPEC’s largest producer) is fully motivated to cut and is looking for a target of 32.5 million bpd. Iran and Iraq (second- and third-largest producers) are the big wildcards, and while they were previously playing hardball, recent developments indicate these countries may be willing to consider a freeze at the very least.
For 2017, the “call” on OPEC production is roughly 33 million bpd. This means that the world oil market would be balanced should OPEC produce 33 million bpd, and, therefore, any cut that is greater than this would be bullish.
Here’s why investors have reason to be optimistic.
Saudi Arabia and the Gulf states are likely to lead the way
While there has been plenty of news coverage about Iraq and Iran standing in the way of a successful OPEC deal, the reality is that Saudi Arabia and its allies in the Gulf states have the power for the deal to be at least somewhat of a success.
As mentioned earlier, OPEC would need to cut 1.1 million bpd to get down to 32.5 million bpd (the most desirable deal). Saudi Arabia is currently producing a record 10.6 million bpd, and at this time of year production usually drops about 400,000 bpd (a normal seasonal decline). This means Saudi Arabia can very comfortably cut 400,000 bpd–a good portion of the 1.1 million bpd of cuts that is needed.
Saudi’s Gulf state allies (Kuwait and U.A.E.) could also likely cut 200,000 bpd (or possibly more). This is reasonable, because Kuwait and U.A.E. are some of the few OPEC nations that actually boosted their production since 2014. (The vast majority actually cut their production.)
This means Saudi Arabia and its Gulf state allies could bring on at least 600,000 bpd of cuts, enough to bring total OPEC production close to 33 million bpd. This, of course, is far from ideal, because it still leaves 500,000 bpd that needs to be cut to reach the 32.5 million bpd mark, and it also doesn’t factor in growing production from other countries.
What is the solution? Saudi Arabia could step in to cut much more. Since 2014, Saudi Arabia has been the main source of the extra OPEC production that sank the oil market, adding over 830,000 bpd since 2014. Iran and Iraq added as well, but for good political reasons. If Saudi Arabia were to simply cut that 830,000 bpd, it would bring OPEC very close to the 1.1 million bpd needed for a good deal.
How you should play the deal
While nobody knows for sure if a deal will happen, given that Iraq recently agreed to cut and that most OPEC producers are in a financially desperate situation, a deal is likely. Investors should use the opportunity to add to names with strong oil exposure now, because OPEC deal or not, the market will continue to re-balance.
Baytex Energy Corp. (TSX:BTE)(NYSE:BTE) is a perfect name because it sold off recently and currently trades at a large discount to its peer group.
