Commentary: Too Many Hands Fiddling With OPEC Temperature Control: Gadfly

Showers, particularly older ones, can be tricky. First, you get hit with a freezing blast, so you turn up the hot water. Nothing happens. You turn it higher, and it warms up — and then keeps warming up. Until it’s scalding. Frantically, you turn up the cold water and stem the hot, and it cools down — and then keeps cooling down. Until it’s freezing …

OPEC, trying to manage the temperature of the oil market, knows the feeling. Except, the controls on this shower have changed and more than a dozen sets of hands are trying to operate them (I’ll end the imagery there).

OPEC, long a motley crowd, had an especially wide array of interests to balance heading into its latest meeting, which wrapped up Thursday in Vienna:

Extend supply cuts to support oil prices; but not so much that prices rise to a level that dampens demand growth … … or sets off a drilling boom elsewhere (Texas, Canada etc.); Set supply, process and timeline for participants (including all-important Russia) at a level they can still live with, while factoring in wildcards like Libya, Nigeria and Venezuela; Do enough to keep speculative money onside, supporting near-term futures prices … … and the prospects of a certain planned initial public offering.This explains Thursday’s outcome. The group has extended supply cuts through the end of 2018 albeit with a review in June. Saudi Arabia’s energy minister emphasized his country’s commitment and its close relationship with Russia. Libya and Nigeria agreed not to raise production further next year.

This extend-and-maybe-amend approach keeps some barrels off the market and, importantly, signals to speculators that the group isn’t done yet.

Meanwhile, the agreement to a review signals that OPEC isn’t ignoring uncertainty on supply, demand and prices and can adjust if necessary. It also signals that this isn’t a permanent arrangement, an issue important to Russia and its oil majors.

In one sense, this is a win for OPEC, an organization with a spotty track record on cohesion.

Yet it also demonstrates the group’s fragility. Start with the obvious: Russia’s involvement is more important than that of many OPEC members, its participation lending critical credibility. This, along with roping in so many other non-members they had trouble fitting everyone into Thursday’s group photo, is as much an expression of OPEC’s weakness as it is of intense diplomacy. The participation of Libya and Nigeria is a positive signal, but let’s not forget Libya can only charitably be considered a country right now.

In addition, an agreement initially penciled in to run for six months will now last maybe four times as long. I say “maybe” because any nine-month extension with an embedded review is really a three-month agreement with an option.

This parsing of the timeline highlights OPEC’s shower problem.

OPEC has moved prices significantly in the past, notably after the financial crises of 1997 and 2008. Controlling them has proven much tougher, and the inability to meet the challenges of China’s demand surge and later Arab uprisings spurred prices to levels that destroyed demand and fueled competing supplies, such as tight oil.

A decade ago, OPEC could at least count on a lag of several years between adjusting the controls and supply and demand reacting, as it took time to drill new wells and consumer behavior to change. No longer. Demand still has a built-in lag, but it now operates in the shadow of the encroaching threat of electric vehicles. And on the supply side, tight oil can react within 6 to 12 months, especially given a huge stockpile of drilled-but-uncompleted wells.

Therein lies the risk of OPEC’s attempt to manage prices with such blunt, and dispersed, tools. By signalling an extension, even conditionally, it is not merely supporting headline prices, but potentially also those further out:

The recent increase in 2017 and 2018 prices has provided U.S. exploration and production firms an opportunity to hedge more near-term output. The tick-up in prices further out, while less dramatic, is a warning. Encouraging those to rise would create a runway for steady increases in U.S. production (and potentially elsewhere).

In a recent presentation, consultancy Rystad Energy forecast output from the Permian Basin at various price levels. At a $45 oil price, it is forecast to rise by about 0.9 million barrels a day by the end of 2020. At $65, the gain would be more like 1.5 million barrels a day.

That is a narrow range of sensitivities for OPEC to navigate. It can take some comfort in the fact that, unlike this time last year, prices beyond 2018 haven’t rallied in lock-step with near-dated ones. Equally, though, that may well also reflect expectations of continuing pressure on production costs, especially outside OPEC, and the belief that, sooner or later, the agreement unravels.

Three years ago, OPEC did the rational thing and flooded the market to squeeze out rival supply, but this proved too painful to maintain. Now, despite those shower controls being fiendishly sensitive, OPEC feels compelled to stay in there for as long as it can.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.