Energy

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

OPEC has delivered. But now it must ... actually deliver.

The oil-producer group announced a grand bargain to cut 1.2 million barrels a day from its own production, along with pledges from other countries such as Russia to pull another 600,000 barrels a day off the market. Taken together, the cuts are roughly equivalent to the combined output of OPEC members Nigeria and Gabon. Brent crude jumped by 8 percent to just above $50 a barrel on Wednesday.

Cut Up
OPEC's pledge got Brent back above $50
Source: Bloomberg
Note: Generic 1st month Brent crude oil futures price. Intraday pricing.

With the short sellers duly thwacked, further gains will depend on actual compliance with those committed cuts -- something OPEC and Russia have struggled with historically. Yet, if oil producers can achieve even half the targeted cut, they will go a long way to draining the glut of stored oil weighing on prices -- with one important caveat.

The Energy Information Administration recently published short-term forecasts for global oil supply, demand and inventory changes. At the end of the third quarter, there was a little more than 3 billion barrels of oil sitting in commercial storage in the countries of the OECD (for the purposes of this analysis, I use OECD inventories as a proxy for the world, as most commercial storage capacity is in those countries). That was enough to meet a little less than 65 days of forward demand, based on estimated OECD oil consumption in the fourth quarter.

To get to an estimate of how much oil would be in tanks by the end of the year, I've adjusted the EIA's forecast of OPEC crude oil production slightly higher, as the organization was producing about 500,000 barrels a day more in October than the forecast implied. Factoring that into the EIA's expectation of how much oil would be drawn from OECD inventories in the fourth quarter yields an estimated year-end level of a little less than 3.1 billion barrels, enough to cover an extra day of forward demand.

From there, the EIA's forecasts suggest OECD inventories relative to forward demand will peak in the first quarter of 2017 at about 67 days, before starting to drop. But adjust the EIA's forecasts for movements in OECD stocks during 2017 for the cuts pledged on Wednesday, and things change significantly:

Deliverance
If OPEC and its partners deliver even half the cuts promised, inventories could start draining quickly
Source: Energy Information Administration, OPEC, Bloomberg Gadfly analysis
Note: Data from 4Q2016 onward are estimates. Data for 4Q2016 adjusted for OPEC's October production data. "Full compliance" and "Half complieance" scenarios reflect EIA estimates for OECD stock movements adjusted for OPEC and non-OPEC production cut pledges. Assumes all global deficits in oil supply are met from OECD inventories.

At full compliance, OECD inventories could drop to a little more than 56 days of forward demand by the end of the third quarter of 2017, more in line with the levels seen before the oil crash began. At half compliance, demand cover would hit about 60 days -- still high relative to the good old days but moving in the right direction.

One obvious takeaway from this math is that OPEC not only needs the deal to hold together but must keep it going after the initial six-month agreement (the organization will decide on this in May).

The caveat? This cut is a capitulation of sorts.

As I wrote here, supporting the market in this way hands an opportunity to U.S. exploration and production firms to hedge future production at higher prices and expand their own drilling budgets to fill some of the gap left by Saudi Arabia, Russia and others.

Over the next six months, we will see if OPEC's coalition can hold. Assume it does -- a huge assumption at this point -- and in the following six months we will see how much the frackers will do to undermine it.

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

To contact the author of this story:
Liam Denning in New York at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net