LONDON, Oct 26 (Reuters) – Senior officials from the Organization of the Petroleum Exporting Countries and its allies are already discussing an extension of their production accord beyond its scheduled expiry at the end of March 2018.
Current production limits have already been extended once, from the end of June 2017 to give more time for the oil market to rebalance.
Ministers and officials are now discussing lengthening the agreement again, possibly until the end of 2018 (“OPEC seeking consensus on oil supply cut extension before meeting”, Reuters, Oct. 19).
OECD crude oil inventories were still almost 160 million barrels above their five-year average in September, though the surplus has already narrowed by nearly 180 million barrels since the start of the year.
On current trends, inventories will not have normalised by the end of March, and OPEC is keen to reassure traders that production limits will be extended until the process is completed.
OPEC and its allies have been engaged in a form of forward guidance, borrowing from the central banking sector, pledging to do “whatever it takes” to bring inventories down to the five-year average.
In the past, OPEC has held multiple ordinary and extraordinary ministerial conferences each year to review and change production policy.
In recent years, however, the organisation has restricted itself to the two ministerial conferences annually required by its statute.
Conferences have typically been held towards the middle and end of each year, normally in May/June and November/December.
And OPEC has generally waited until a production agreement is close to expiry before deciding whether to extend or adjust the deal to preserve the organisation’s flexibility to respond to changing market conditions.
The problem is that the current production agreement expires in March 2018, which is midway between the already scheduled meeting in November 2017 and the next one likely in May or June 2018.
OPEC ministers could agree to meet again in March 2018 to review the agreement and decide on whether to extend or modify it, which would maximise their flexibility.
But they are under pressure from political leaders and oil traders to extend the agreement beyond March to complete the process of inventory normalisation.
The most important participants in the negotiation, Saudi Arabia and Russia, have already signalled their interest in extending the agreement beyond March.
So the questions are (1) how long to extend the agreement for and (2) whether to make it explicitly or implicitly conditional on some form of interim review.
The simplest strategy would be to extend the agreement for three months until the end of June 2018, which would allow it to be reviewed again at the next regular ministerial conference.
The upside of a three-month extension is that it would maximise OPEC’s flexibility as the oil market gets close to balance, and align production limits with OPEC’s regular meeting cycle.
But it would risk disappointing traders and hedge funds who expect OPEC to do “whatever it takes” and are hoping for a bolder and longer commitment to production restraint.
A second strategy is to extend the pact for a full nine months, until the end of December 2018, which would also align the accord with the regular meeting cycle.
A nine-month extension would be bold, underscoring OPEC’s commitment to cutting stocks, but it would limit the organisation’s flexibility significantly.
In effect, OPEC would be committing to hold production unchanged for 12 months (the three unexpired months of the existing agreement and then nine months of extension).
With oil inventories declining steadily, the oil market moving from contango to backwardation, and spot prices on a rising trend, OPEC would risk losing control of the rebalancing process.
Given the current rate of drawdown in crude oil stocks, a 12-month extension would pose a significant risk of inventories and prices overshooting.
So OPEC could try an intermediate strategy: a firm extension for three months to June 2018 with an option to extend the production cuts for a further six months, conditional on market conditions in the middle of 2018.
There are several ways to structure an intermediate strategy, with the mid-year review and option for extension made more or less explicit, depending on what signal ministers want to provide to the market.
If the extension is firm only for three months, with any further extension explicitly conditional on a review at mid-year, there is a risk of disappointing traders and hedge funds, but OPEC would retain maximum flexibility.
Alternatively, OPEC could make the extension firm for nine months, and leave implicit the fact it will be reviewed at mid-year and any decision to prolong it will depend on market conditions at the time.
Ministerial conferences can always review and change production limits in the light of shifting market conditions, but negotiators might choose to leave this unspoken.
OPEC and its allies have also created a Joint Ministerial Monitoring Committee and an experts group, which carry out more frequent reviews of compliance and market conditions.
So far, the ministerial monitoring committee has not been authorised to recommend intermediate changes in the production deal but it could provide a vehicle for an interim review outside the normal OPEC cycle.
Ministers therefore have lots of options as they consider an extension of the current production pact beyond March 2018.
At some point ministers will also have to consider revised production limits once the current pact expires, which could prove a source of contention since some countries have much more spare capacity and ability to raise output than others.
Difficult decisions on a successor pact may therefore be put off as long as possible.
In the meantime, ministers must balance forward guidance to support prices with retaining flexibility to respond to changing market conditions, which are starting to shift rapidly.