When it comes to OPEC production cuts, “We tend to cheat,” said former Saudi Arabia Oil Minister Ali al-Naimi after the group reached an agreement to curb output late last year.
But the extent of that cheating won’t be too bad this time around, reckons Goldman Sachs Group Inc.’s Damien Courvalin. The analyst sees OPEC and non-OPEC nations enacting a full 84 percent of their agreed-upon cuts, citing the incentive among lower-cost producers to “fast-forward the normalization in inventories.”Such a move would effectively alter the shape of the oil futures curve, ensuring that competing shale producers will be less likely to lock in 2018 production as longer-dated contracts cheapen relative to near-dated ones, helping to reduce the global glut in crude. The dramatic change in the shape of the Brent futures curve over the past five weeks may be an early sign that the tactic is poised to bear fruit.
While the curve was in a state of contango before the November 2016 agreement — meaning near-dated oil delivery contracts were less pricey than longer-dated contracts — part of the curve has now shifted into the opposing state of backwardation, meaning a contract expiring in December 2018 is now trading at lower price than contracts expiring in September 2017, for instance.
This dynamic can make locking in next year’s production a less attractive prospect for higher-cost shale drillers, Courvalin explains, and will expedite the market’s return to balance and foster a “meaningful” drawdown in previously built-up stockpiles of crude. There are also ancillary benefits to consider for major producers that may be planning on selling a stake in their state-run oil companies, which the analyst alludes to.
The “normalization of inventories is key to low-cost producers,” he writes in a Jan. 4 note to clients, as “it generates backwardation, which removes hedging gains from high-cost producers and helps low-cost producers grow market share,” he said. It also “reduces oil price volatility, which increases the valuation of the debt and equity they are issuing.”
Of course, the swiftness of the response of U.S. shale companies, which expanded output in October by the most since April 2014, could throw a wrench in the analyst’s estimates.
Courvalin forecasts that Brent prices peak at $59 per barrel in 2017 amid these inventory draws, but warns that investment in new projects will pick up steam as crude stabilizes between $55 and $60 per barrel, effectively capping the upside for front-month prices.
As such, he expects better returns from futures than the spot price, as the current structure of the curve provides opportunities for positive carry.