Matthew DiLallo | –
Given the recent market whispers that OPEC will extend its output cuts, it suggests that the oil cartel thinks that oil prices are still a bit too low for its liking.
Last fall, OPEC sent shock waves through the oil market by agreeing to its first output cut in eight years. That decision marked a notable policy shift by the oil cartel, because it meant the abandonment of its pump-and-dump strategy, which it instituted in an ill-fated attempt to push high-cost shale producers out of the market. While that previous plan did drive the price per barrel below the breakeven level of most shale producers, it also led to breakthroughs in the drilling cost structure.
That said, OPEC’s latest policy doesn’t seem to be having the desired impact, either. One look at an oil-price chart shows that oil today isn’t much higher than it was when OPEC made its policy change:
That stagnant price level, along with recent comments from oil ministers, suggests that OPEC thinks current oil prices are still too low. However, that doesn’t mean it’ll be in a rush to provide further support.
Budgeting for a big year
OPEC’s de facto leader, Saudi Arabia, gave the market a subtle hint of where it thought crude prices were heading in 2017 when it released its fiscal budget late last year. The kingdom projected that it would pull in $128 billion from oil sales in 2017, up a staggering 46% from last year. According to analysts, the country’s base case is that crude would fetch around $55 per barrel this year, though it only needed oil around $50 to balance the budget. By setting its base case around $55, the Middle Eastern nation could generate a surplus to reduce the national debt, which more than doubled last year because of low oil prices.
Meanwhile, several other OPEC countries used a lower oil price when setting their budgets. Nigeria, for example, based its budget on $42.50 oil. However, it needed oil much higher to balance its budget, with a mid-$50 oil price potentially cutting its budget deficit in half.
Whispering what might come next
Ideally, OPEC hoped that its initial six-month deal to reduce oil output would fix the oil market’s oversupply problem and put a floor under oil prices somewhere in the mid-$50s. However, given the continued climb in U.S. oil inventories — which remain near record levels and caused oil to sell off in recent weeks — it appears that this plan isn’t working as quickly as expected.
OPEC members have therefore started to signal an openness to extend their output cuts. For example, OPEC’s monitoring committee recently met to discuss the status of the agreement, and according to reports, several members expressed support for an extension of the deal beyond this June. One of those was Iran’s oil minister, who said that “it seems that most of the OPEC and non-OPEC (countries) are going to extend the agreement, but time is needed to evaluate the situation and to have face-to-face meetings and discussions with others.” Those comments signal that many in OPEC aren’t happy with where oil prices are at the moment.
The problem of propping up the oil market
Still, OPEC needs to weigh the weaker-than-hoped-for current oil pricing level with the potential for a problem down the road if its actions take crude prices up too far too fast. That’s a scenario Goldman Sachs recently warned against when the investment bank said that an extension of the cuts could backfire and cause a sharp price increase above $60 a barrel, which might cause U.S. shale drilling to come roaring back.
For example, leading shale driller EOG Resources expects to grow its oil output 18% this year while living within cash flow at $50 crude. However, it has an abundance of low-cost drilling locations, enabling it to quickly ramp up its oil growth rate at higher oil prices. In fact, EOG Resources projects it can ramp its oil growth rate up from 15% annually at $50 oil to 25% annually if crude averages $60 a barrel.
EOG Resources isn’t alone. Diamondback Energy expects to grow its production by a remarkable 60% this year while living within cash flow thanks to the impact of a recent acquisition and organic drilling. Yet it plans to run only eight rigs this year to achieve that growth rate, which is well below the 15 to 20 rigs it can run across its expanding acreage position. It’s a resource base that provides Diamondback Energy with a “runway for unprecedented growth for years to come,” leaving it ample room to accelerate its drilling program and pull growth forward if oil prices rise sharply. Several rivals possess similar upside given their low-cost position in U.S. shale plays, which is something that might cause OPEC to remain cautious.
It’s becoming clear that OPEC doesn’t like where oil prices are at the moment. But given shale’s growth potential, OPEC has to walk a fine line between the desire for higher oil prices and the risk of setting off another shale boom. That’s why it’s entirely possible that it might wait until the 11th hour before committing to extending the output cuts, not wanting to provide shale drillers with any incentive to accelerate.
Matthew is a Senior Energy and Materials Specialist with The Motley Fool. He graduated from the Liberty University with a degree in Biblical Studies and a Masters of Business Administration.