The biggest question in oil markets is what OPEC should do once its deal to cut output ends next spring. Goldman Sachs Group Inc. has an answer, but it requires a bit of balancing.

Oil prices have slipped 8% since OPEC and its allies agreed on May 25 to keep production reduced until next April amid uncertainty about what they will do after that. For Goldman Sachs, the organization’s challenge is to reduce supplies enough in the short term without boosting prices so much that rival producers get back to work.

To juggle those objectives, OPEC should make deeper production cuts now and simultaneously warn it will revive output sharply once the surplus clears, according to Jeff Currie, the bank’s head of commodities research in New York. As a result, long-term prices would fall below short-term prices — a structure known as “backwardation” — making it harder for OPEC’s competitors to finance any comeback.

“OPEC should have cut deeper, as opposed to longer, to generate backwardation, as well as communicated to the market a credible threat of larger market share,” Currie said by phone. “That would put more downward pressure on the back end of the curve, discouraging future investment.”

Saudi Arabian Energy Minister Khalid al-Falih said on May 25 that although the Organization of Petroleum Exporting Countries hasn’t developed an “exit strategy,” it won’t completely abandon managing the market once the current arrangement expires on April 1. That’s still left traders speculating the group may return to its previous approach of pursuing market share regardless of the consequences for prices.

Managing exports

Goldman’s proposal for managing the transition isn’t without difficulties.

For a start, OPEC is still struggling with the first part of the strategy — proving its commitment to reducing the world’s bloated oil inventories, according to consultants Energy Aspects Ltd. in London. The group needs to back up production cuts with a corresponding reduction in exports, the company says.

“To turn sentiment around, key OPEC members should quietly take additional barrels off the market,” said Amrita Sen, the consultant’s chief oil analyst. “The market will not give OPEC many more chances.”

Global stockpiles expanded in the first quarter as the producers ramped up exports just before the deal to cut started in January, according to the International Energy Agency. While they’ve subsequently shown a strong commitment to delivering the cutbacks promised, that has encouraged America’s shale drillers, who have deployed more rigs for 20 weeks in a row, Baker Hughes Inc. says.

Market share

“Ever since the original OPEC agreement was achieved last November we’ve been advocating it would not have a lasting price effect and only lead to market share shifting away from OPEC towards U.S. shale,” said Eugen Weinberg, head of commodities research at Commerzbank AG in Frankfurt. “The only viable long-term strategy for OPEC remains to do nothing, and increase its production instead.”

There could also be an issue with Goldman’s proposal that OPEC should make a statement aimed at depressing longer-term prices and investment, given that officials have often justified the current intervention as intended to reverse the impact of recent spending cuts in the oil industry and prevent a future supply shortfall.

Nonetheless, focusing on market share again would be consistent with OPEC’s approach when previously making output cuts in the past, Goldman’s Currie said.

“There is a precedent for them successfully doing this, which is the late 1980s and 1990s,” he said. “They just ramped up production continuously over that time period.”

Source: www.worldoil.com