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Another heave for Opec

Opec must extend its deal or face another sell-off. Then it needs to find an exit strategy

A consensus in the market has taken shape. Supply and demand "balance" is in sight—not imminent, but cuts and oil-demand growth are doing their job. The assumption, endorsed by sources in Opec, is that the cuts need one more effort to finish the job. That means extending them beyond April 2018, their current deadline, possibly to the end of the year. Saudi Arabia and Russia—the only two parties to the Opec-non-Opec deal that matter—are understood to favour this. The plan, say people familiar with the negotiations, may be announced in Vienna on 30 November.

Don't be mistaken, though. Opec is in a bind.

The language around the cuts over the past year has been about reaching some point of balance, measured OECD stock levels returning to their (rolling) five-year average. When this surpluscalculated in October by the International Energy Agency (IEA) to be around 170m barrelsis gone, this implies, the ordeal should be over.

Yet for several reasons, this stock-reduction metric, first clarified by Saudi energy minister Khalid al-Falih in a Bloomberg interview last spring, might lose some of its meaning in 2018.

First, the stock target is a means to an end, and the end is a higher price. Yet one doesn't necessarily follow the other. The surplus is a symptom of the illness (more oil than the world wants at the quoted price). If curing it just means a crude oil glut has become a products one, the market should call bluff. The same is true if the surplus simply moves from storage facilities into a surfeit of oil in drilled-but-uncompleted wells.

The focus on OECD stocks has tended to overshadow the quest for higher oil prices too. The cutters needed first to staunch the losses and then retrieve the price. The cuts have managed the first job, installing a floor at around $45 a barrel, but the upside has been modest. The spectre of pent-up supply awaiting a strong rallythe tight oil factoris keeping a ceiling at around $60/b.

That's not enough for most of the countries that signed up to the deal. Of the Opec cutters, only Kuwait can keep its budget in the black comfortably at $55/b, according to the IMF. Saudi Arabia, as ever doing the heavy lifting within Opec, needs $84/b. Russia needs $74/b, according to Fitch, a ratings agency.

Absent some major shock, reaching those lofty levels looks far-fetched. The past six weeks have been rife with the kind of news that would once have lifted the price. Donald Trump tried to scrap the US' part in the Iran nuclear deal; Iraqi and Kurdish forces fought over oil infrastructure; and in the background, a host of other producer countries continued to decline, from Yemen and Syria to Venezuela. The fact that all this was worth just a buck or two on Brent says it all about price sentiment.

So Opec nears another meeting knowing that its hands are largely tied. It has to stick with its cuts because its members can't afford another lurch lowerand the deal is the only game in town.

The IEA expects demand to drop from 98.51m b/d in Q4 2017 to 97.9m b/d in Q1 next year

But that raises another problem. It stretches the economic definition of market equilibrium when producers that together account for about 45% of supply are artificially withdrawing their product to achieve the balance. Cutting the output of a commodity by agreement is not the same as supply being rationalised by price.

That's not just some arcane matter of economic theory. It has a major practical application to Opec's dilemma in the coming year, because at some pointmaybe when the OECD stock overhang is goneproducers like Iraq, Iran, Russia and even some of the big Gulf ones will want to start increasing supply again.

Assume that this decision is made in mid-2018, whenkeep assumingthe stocks target has been met. The IEA expects the call on Opec's oil next year will be 32.5m barrels a day. But September's production, including Libya and Nigeria (both exempt from the cuts), was 32.65m b/d. The deal has cut 1.2m b/d from Opec's supply and most of thataside from output capacity lost in countries like Venezuelacould come back into the market. Stocks would start building again and the market turn bearish.

It's no surprise that some in the market compared this dilemma with that of the world's big central banks and their monetary-easing policies. Cutting interest rates, in some cases into negative territory, was supposed to work as shock therapy to revive the economic system after the global financial crisis. Nine years later, American, Japanese, European and UK interest rates all remain at historical lowswith the global economy reliant on the anti-depressant of nearly free debt.

Opec's cuts aren't of the same historic magnitude as central banks' special measures. But the impact of reversing them could be just as shocking for anyone who sells oil. From Calgary to Calcutta, producers now have faith in the price floor Opec installed. Removing it would devastate budgets anew.

It would also be disastrous for the cutters themselves. They've already lost one battle for market share with more efficient producers elsewhere. Opening the taps again would launch another price war. This is sub-optimal, if, like Saudi Arabia, you're at the start of both sweeping economic reforms and a plan to sell some of your state-owned oil company.

No permacuts in the permafrost

All this means that, in November, Opec needs to manage its message with unusual care. To maintain high levels of compliance it must be clear that some sticky patches lie ahead. To avoid worries about a cliff-edge conclusion to the deal, it should explain that output will rise gradually when the deal does end. Saudi Arabia would have to commit to a modest increase, say from around 10m b/d now to a maximum of 10.4m b/d over time, and probably keep its exports to the US low. Opec could not go back to the free-for-all of late 2016.

And then it needs some good luckor an unexpected surge in demand. This is because further tests will begin Q1 2018, when balances look likely to be "ropey", acknowledges one Opec insider. The IEA expects demand to drop from 98.51m b/d in Q4 2017 to 97.9m b/d in Q1 next yeara far bigger quarter-to-quarter fall than in the same periods of 2016 (150,000 b/d), 2015 (100,000 b/d) or 2014 (400,000 b/d).

Even worse may be in store. Barclays says the rebalancing is "fragile and could reverse", and that the inventory drawdown will be "temporary"even if Opec extends through 2018. It reckons crude supply will outpace demand between November 2017 and June 2018 by 1.2m b/d, adding that "the stock draws of the last three quarters should be matched with an average build of the same magnitude in Q1-Q3 2018".

If so, a price drop early in the year would raise doubts again among some reluctant cutters about why they are still cutting, making the exit strategy even trickier.

That's especially the case because of Russia's involvement. Without Moscow's agreement, Opec's deal will collapseone reason Saudi Arabia has spent so much diplomatic capital building its relationship with Russia. Russian producers, though, are in a transition phase, moving from declining brownfield workhorses to new greenfield projectsand all of these have potential to yield supply growth in 2018.

Opec nears another meeting knowing that its hands are largely tied. It has to stick with its cuts because its members can't afford another lurch lower

Sticking to the cuts deal with Opec is a political decision and for now the Kremlin seems to remain in favour. President Putin says Russia "does not rule out" extending the cuts until end-2018. He's understood to have told Opec secretary-general Mohammad Barkindo that he is pleased with the deal so far.

Yet Russian producers have also been able to maintain steady oil-export growth since Moscow signed up to the cutsso they haven't much affected the bottom line. How long can that last? Another heave, maybe, to get through 2018. But it seems doubtful that Russia's big producers, having foregone their planned output increases in 2017, will happily do so indefinitely. Vagit Alekperov, the head of Lukoil, said recently it would be "inappropriate" to keep cutting if oil prices are at $55-60/b. Igor Sechin, head of Rosneft and Russia's most influential oilman, is understood to have told a recent board meeting that his company would accept an extension, without seeming terribly happy about the prospect. He's also been clear that Rosneft is ready to pump hard again. "If something goes wrong, we will not let them occupy our markets," he told the FT in June, referring to the possibility of an "abrupt" end to the Opec deal.

That means the decision to end the cuts probably won't be made in Opec's headquarters on Helferstorferstrasse, but in Moscow. And for all the cooperation of the past 15 months, including King Salman's recent trip to the Kremlin, Russia and Saudi Arabia remain competitors. While the kingdom has cut about 0.5m b/d from its baseline output of 10.6m b/d since the cuts began, Russia has slowly cut 320,000 b/d from 11.6m b/dbut in the same time has replaced Saudi Arabia as the biggest exporter to China. It's not hard to see how this relationship could start to fray. Before it does, Opec and its partners need to find a way of ending their extraordinary measures in an orderly and credible way.

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