Expectation for Doha may be Inflated

The weekend meeting between many OPEC and non-OPEC producers has helped spur the recent gains in the price of oil.  We are concerned that market may be getting ahead of itself.  

First, the freeze in output that had previously been agreed by Russia, Saudi Arabia, and a few other countries was conditional on participation by Iran.  We have consistently been suspicious of this condition.  Iran has sacrificed or at least delayed its nuclear development in exchange for the lifting of the embargo.  If it were to agree to limit its output, it would have made the concessions for nothing.  This cannot be politically acceptable.  

Our reading is that Saudi Arabia was cognizant of this, but providing the condition did a couple of things for it.  It deflected the blame for low oil prices away from it and toward its rival Iran.  It also pushed a wedge between Iran and Russia. 

Second, for many producers, a freeze is not really a concession.  Many producers are operating near capacity.    They have stepped up output to make up for the lower price.  This is a rational strategy under some conditions. 

Third, there was an unintended disruption in supply in Iraq and Nigeria which are being resolved.  Iraqi output reportedly rose 2% in March.  Reports indicate that Saudi Arabia and Russia also increased their output ahead of the tentative freeze agreement in February and afterward.  This too seems to be a rational strategy under certain conditions.    

Fourth, some OPEC countries are looking to expand capacity.  Kuwait, for example, reportedly will soon seek assistance to access undersea oil reserves for the first time.   Projections suggest it would boost capacity by 5% or more. 

Earlier today, OPEC projected a greater decline in non-OPEC output than it did last month.  It now assumes that non-OPEC output would fall by 730k barrels a day this year.  This is about a 5% larger drop than projected in March.  In addition to the decline in US output, it is also anticipating a further drop in Chinese output as some fields mature.  OPEC is also expecting a larger drop in UK output.   There are reportedly many fields in Russia that are also maturing and cuts in investment are preventing their replacement. 

Separately, we note that China imported a record amount of oil in Q1 16.  Over the past few years, China has built substantial refining capacity, drawn by the wide margins.  There are some indications that as often is the case in China, it quickly developed over-capacity, which squeezes margins as its exports its surplus. 

We suspect that many observers do not fully appreciate the tension between Saudi Arabia and Iran.  The two OPEC countries are aggressively competing on a number of fronts, including but not limited to market share.  Reports suggest each has taken action to undermine the other, including frustrating shipping efforts. 

Also, we see many observers citing old breakeven levels for US shale producers.  As far as we can tell, there is near constant technological improvement, and this has lowered the breakeven of some of the largest US producers toward $40 a barrel from $60 a barrel.  

A freeze in output would take place at elevated levels.  The EIA estimates that surplus is about 1.4 mln barrels a day this year.  This is down from 1.59 mln from the previous estimate.  The excess output next year is projected at 410k barrels, down from 640k.    Our reading of the literature suggests many observers have underestimated the resilience of US output and how quickly it may return. 

US crude inventories are still rising at about a 10% year-over-year rate.  This is down from around 29% in the middle of last December, the peak in the cycle. 

Open interest in the light sweet crude oil futures contract has shifted to June from May.  Yesterday the June contract rose through the March high near $43.20.    Prices bottomed on the June contract on January 20 near $30.80.  There has been a five-leg advance off the low.    Today's flat consolidation does not mean much, and there is potential toward $45.   Beware of buy the rumor sell the fact. 

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