Vienna accord – how OPEC’s agreement was preordained

Pessimism hung over the crude oil trading market on November 29th, the day preceding the 171st Meeting of the Conference of the Organization of Petroleum Exporting Countries (OPEC). The chaos that appeared evident among the key members of the organization heading into the final few days ahead of the meeting led traders and the energy media to throw substantial cold water on the likelihood of any agreement being forged…or certainly one that would stand the test of time, if only for 24 hours. Crude oil prices were falling as traders began covering their optimistic bets on oil’s future and shifted their bets to lower prices anticipating a failure of the meeting to be announced. Lo and behold – in the early morning hours of November 30 in New York City, the rumors flew that an agreement had been forged among the key OPEC members, but more importantly that Russia was onboard with cutting production to help accelerate the oil market’s rebalancing.

When the market opened, euphoria ruled in the oil trading pits and on Wall Street where energy stocks soared – extending the Trump Bounce that had been lifting stock prices since the election. By last week, however, the wind seemed to be coming out of the sails of the market as analysts suggested that OPEC would announce another record production month, along with Russia, and putting in doubt the sustainability of the agreement. Since it doesn’t become effective until January 1, 2017, it is not surprising that OPEC members are boosting their output, hoping to get a few more dollars into their treasuries by selling more output at oil prices above $50 a barrel.

After being shocked once again by the performance of OPEC members, reporters began digging to try to understand how this agreement came together. The reporters’ objective was to finger who won and who lost in the negotiations. There had to be a kingmaker – and they found him when they learned of a 2 a.m. phone call between Saudi Arabia Energy Minister Khalid Al-Falih and his Russian counterpart Alexander Novak. Mr. Novak said that Russia was not only willing to cap its output, but would agree to cut it by half the non-OPEC volume the organization needed to put together a grand bargain and bring the oil market back into balance. Telling the story was much more fun than digging into the data and attempting to understand what, if anything, had changed or was in the process of changing, in oil’s fundamentals that might have facilitated the OPEC deal.

In November 2014, when Saudi Arabia decided to allow market forces to determine crude oil prices, to the world’s shock, the media’s storyline became that the Kingdom was waging a war against American shale producers who had revolutionized the finding and development of new oil supplies never thought capable of becoming a sustainable resource. These explorers’ success had more than doubled U.S. oil output between 2005 and 2015, which contributed to a huge global inventory surplus. The issue of weaker than expected oil demand growth and the European Union’s reversal of its view on the acceptability of “dirty” oil sands supply was ignored in the story. The shale supply performance was largely due to nearly a decade of extraordinarily high crude oil prices, enabling the financing of expensive shale wells. Projections of never-ending high oil prices sustained the fever.

A review of trends within the U.S. and global oil markets may help explain why the OPEC deal came together. According to the story-line of OPEC’s 2014 decision being an attack on U.S. producers employing fracking technology, those companies were targeted for causing Saudi Arabia and OPEC to lose market share in the U.S. A long-term view of U.S. crude oil imports from OPEC shows how its share of supply had fallen over time. In the mid 1970s, OPEC supplied about 80% of U.S. oil imports, which fell quickly and dramatically to about 30% by 1982. Three forces explain that decline: the high price of oil following the Arab Oil Embargo; the collapse in consumption following the two significant price hikes of the 1970s and the resulting recession; and the growth of non-OPEC supply sources such as the opening of the North Sea and the development of West African oil supplies.

By the end of the 1980s, OPEC had regained U.S. market share, getting it back to nearly 60%. From that point forward, OPEC’s market share fell slowly as more diverse supplies became available. The trend in OPEC’s market share, and the challenge it presented for the organization becomes clearer once we look at data for the past decade. From 2006 to mid-2008, total OPEC imports rose, while total U.S. oil imports declined, boosting the organization’s share from the low 40s% to the mid 50s%.

Exhibit 1. History Of OPEC’s Share Of US Imports 

Source: EIA, PPHB

Although the overall trend in OPEC’s share of U.S. oil imports was downward, by 2014 it had fallen back to the low 40%. In September 2014, OPEC’s market share of U.S. oil imports sat barely over 40%, but then dropped sharply – bottoming out in the mid 30s%. That share began climbing again but it was not until recent months that it exceeded 40%.

Exhibit 2. The Past Decade Of OPEC’s US Imports

Source: EIA, PPHB

Focusing on a narrower timeframe – January 2014 to now – shows how the OPEC market share shift has occurred. Starting in spring 2015, absolute OPEC imports began growing slowly. It wasn’t until the end of 2015 that total U.S. imports began growing. That was largely a function of fuel consumption growth, as Americans were driving more, at the same time U.S. oil production was falling. With OPEC’s market share holding firmly above 40%, and certain OPEC and non-OPEC producers having serious production problems – Mexico, Venezuela and Nigeria – the outlook for OPEC’s volumes, especially those from Saudi Arabia, coming to the U.S. appears solid.

While Mexico may be able to restore some of its lost production, it will take substantial sums of money and time for that to occur on a sustainable basis. Venezuela’s problems are deep-seated and involve the government and the governed. The health of the country’s economy and its finances are so poor that it will likely take a political revolution and substantially higher oil prices for an extended period to revive its oil industry. How long that might take is anyone’s guess, but it likely won’t happen quickly.

Exhibit 3. How OPEC’s US Importance Has Improved

Source: EIA, PPHB

From over one million barrels a day in 2010, Nigerian oil imports to the U.S. fell steadily hitting zero or the very low tens of thousands of barrels a day in 2015. Import volumes rebounded in spring 2016 to the low 300,000s of barrels a day before falling back to half that volume by August and September. Some of this volume increase may be attributed to the reduced anti-oil violence in Nigeria, but maybe more to declines in supplies from Algeria, Libya and Angola. Also, Saudi Arabia’s imports have grown in recent months by 100,000-300,000 barrels per day. What we don’t know about the imports from these countries is the quality of the crude oil. That is an important ingredient in understanding what is happening in the domestic oil market.

Exhibit 4. Light Oil Imports Have Suffered From Shale

Source: EIA, PPHB

When we examine the import volumes and crude oil quality, we find some interesting trends. Since 1983, the three-month moving average of crude oil imports have grown overall, but the mix in the quality of the crude oils coming into the U.S. tells an interesting and important story. From the early 1980s until the mid-2000s, there was dramatic growth in light oil (API gravity of 30.0-45.1 degrees or greater) imports. After that point, these light oil imports shrank meaningfully, with the absolutely lightest oils disappearing entirely from the import scene. It is also interesting that during this same time period, heavier crude oil volumes – 30.0-20.0 degrees or less – being imported in the U.S. have grown substantially. This is largely a result of the refining industry’s operating philosophy adopted some years ago that in the long term, the world’s crude oil supply would become heavier (lower API degree numbers) and more sour (higher sulfur content). It was in response to these trends, which became more evident as U.S. domestic oil production declined in the 1970s to 1990s. To counter these trends, U.S. refineries were reconfigured to handle more heavy and sour crude oil supplies and less light and sweet oil. In many cases, this involved the voluntary destruction of the catalysts used in the refining process since that facilitated increased use of lower quality crude oil supplies. These trends become evident when one examines the long term trends in the quality of oil going into refineries.

In examining Exhibit 5, one sees how the quality of refinery crude oil input has become heavier (the downward slope in API gravity) and more sour (the upward slope in sulfur content) since the mid-1980s. Maybe more interesting is that the trend toward heavier crude oil bottomed in 2005 and then trended toward a lighter crude oil mix before jumping up in 2013 to a significantly lighter crude oil mix. We are not sure exactly why there was such a spike toward a lighter crude oil mix, but almost half of the rise in 2014 has been erased. Still, the mix of crude oils going into America’s refineries today is slightly lighter (just over one degree more) than it was in the mid-2000s.

Exhibit 5. US Refineries Are Using Lower Quality Crudes

Source: EIA, PPHB

Why is this important? Maybe because the rise in domestic tight oil production has resulted in significantly greater light oil volumes being available. Note that in Exhibit 6, the sharp increase in tight oil output coincided with the refining industry’s mix of input becoming lighter. We are not sure whether the recent decline in tight oil output due to the drop in global oil prices and reduced drilling activity, just happens to coincide with the drop in the gravity mix of oil volumes going into refineries, or whether some other factors are at work.

Exhibit 6. Refinery Light Oil Use And Tight Oil Output

Source: EIA, PPHB

When we look at the mix of oil production in America by ranges of API gravity (Exhibit 7), the average of the output hasn’t changed materially. This was a little surprising, but it is probably due to the fact that production volumes didn’t change materially in the short time span of available data. If we had API gravity data for oil produced in say 2010 or even 2000, we likely would have seen a greater change.

Exhibit 7. How US Oil Production Has Become Lighter

Source: EIA, PPHB

When we examined the percentage distribution of crude oil volumes for January 2015 and September 2016 by ranges of API gravity, there was not a noticeable difference. To test this conclusion, we decided to calculate the cumulative gravity distribution of oil volumes flowing into refineries, going from heaviest to lightest oil volumes. While there appeared to be a slightly lighter crude oil slate, as measured by the heavier gravity volume percentages represented, the difference was not material. We confirmed the conclusion by adding up the oil volumes for API gravities 40.1-55.1 and greater to see the percentage of the total volumes they represented. Between early 2015 and this September, the slate’s mix changed by only 0.2%, despite oil production volumes falling by nearly 700,000 barrels a day.

When we examine this data in conjunction with the data contained in Exhibit 4 that shows a declining API gravity mix of imported crude oils, it is easy to conclude that we are using more of our current tight oil production to displace those imported light oil volumes. Several questions arise from this analysis. First, what happens when domestic oil output begins rising again? How much light oil supply can our refining industry effectively utilize? What happens to our shale oil business if exporting domestic crude oil is banned again? Will we see new refineries built that are based on the increased tight oil output, especially if the optimistic production projections can be realized?

PHOTO: Members of OPEC convene at the Vienna meeting. SOURCE: OPEC

BY : Allen Brooks

A distinguished professional with a 40-plus year in the energy and investment industry. A consultant to multiple oilfield services companies.