Vol. 1 Issue 14 25 November 2016

ALL I WANT FOR CHRISTMAS… IS A FREEZE

The good news is that in less than a week, we shall know what OPEC — and non-OPEC (in effect Russia) — finally do with their intentions to limit crude output in a bid to bump up prices.

The bad news is that this won’t be the end of the guessing game, market anxiety, or price volatility. Far from it.

An accord to limit crude production, if that is indeed what the producers’ group delivers in Vienna November 30, would end nine difficult months of gestation since Russia and OPEC first floated the idea of a “freeze” early this year. But it would be the beginning of what might arguably be one of the most challenging production restraints in R-OPEC’s history, vulnerable to sabotage due to mutual suspicion and the pressures of deteriorating economies from within, and the threat of a resurgent US shale sector from without.

There seemed to be a queue of producers wanting to trip up the proposed agreement as it entered the home stretch this week. First it was Iran and Iraq, among OPEC’s top three producers and the biggest contributors to its more than 2 million b/d growth in output since 2014, flip-flopping over their participation. And then it was a recalcitrant Russia, capping the final days of OPEC’s intensified shuttle diplomacy by saying that all it could offer was a freeze.

At this writing, the numbers in circulation were 1.1 million b/d targeted for an OPEC cut, with a 500,000 b/d contribution from non-OPEC producers, which would presumably include Russia, Azerbaijan, Kazakhstan, Oman, Brazil and Mexico.

Just over a million barrels per day is about 3.3% of OPEC’s output

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• Last-minute flip-flops by Iraq and Russia may not scupper an OPEC deal, but place the onus on Saudi Arabia to make everyone toe the line or bear the brunt of a cut.

• A new target of 32.5 million b/d with dispensations for Iran, Iraq, Libya and Nigeria could mean the Saudis taking a cut of 1 million b/d. Or settling for a higher ceiling.

• Irrespective of the size and distribution of the new quotas November 30, the market could be in for a wild ride, as attention shifts to discipline against the targets.

• One of Donald Trump’s many campaign threats was to “rip up” the Iran nuclear deal. He has not spoken about it since election day, but there are signs of moderation.

• The Mexican government has raised the volume of its oil hedges for 2017; the IMF says it may help protect revenues as domestic fuel sales are deregulated.

How do I cut for thee? Let me count the ways…

• I could “cut” from the higher output I planned

• I could “cut” from my own (higher) baseline

• I could “cut” when I can’t produce any more

Vol. 1 Issue 14 25 November 2016

using the 33.64 million b/d October figure. Half a million barrels per day translates to a 2.5% cut, going by the estimated combined production of the six non-OPEC producers mentioned above.

If Iran is exempted from a cut till it reaches 4 million b/d and Iraq is allowed to cut 3.3% from a higher baseline of 4.7 million b/d within the OPEC math (which, incidentally, amounts to the same as “freezing” its output at the 4.56 million b/d figure cited by OPEC for October), while Russia gets away with a freeze instead of reducing output in non-OPEC, in the worst-case scenario, it could prompt other members in the respective groups to demand similar treatment, turning the Vienna negotiations into a nightmare. At the very least, it would sow the seeds of disgruntlement, which doesn’t bode well for compliance in the months ahead.

Iran, Iraq and Saudi Arabia together account for around 56% of OPEC’s current output. In order for the above-mentioned dispensations for Iran and Iraq to work with a 1.1 million b/d cut against OPEC’s October output, which would mean a new ceiling of around 32.5 million b/d, one option would be for the Saudis to pick up the slack. That would mean them cutting by a little over 1 million b/d, instead of their equitable share of about 347,000 b/d.

If the Saudis are to also shoulder what would have been the 3.3% Libyan and Nigerian shares of the total 1.1 million b/d cut, our calculations show they would need to climb down to around 9.39 million b/d. But the

Kingdom is said to be unwilling to go below 10 million b/d.

All in, while the road to an agreement has been long and torturous, the likely outcome scenarios appear to be relatively straightforward:

— a meaningful OPEC cut of 1 million b/d or more with the Saudis taking a larger than proportional share

— a face-saving but in theory an ineffective reduction of less than 1 million b/d, distributed equitably among the group’s 11 members after exempting Iran, Libya and Nigeria

As for non-OPEC participation, at this stage, OPEC’s credibility is at stake and it does not seem to have much leverage. It might have to live with a freeze from that camp, if that is all it gets.

COULD TRUMP COME TO OPEC’S RESCUE?

Oil markets can't live without to speculation. Donald Trump has so far made no mention of his plans with regard to the Iran nuclear deal since his election November 8, a topic conspicuously absent from his 158-second YouTube video on his policy plan for the first 100 days in office, as well his

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Vol. 1 Issue 14 25 November 2016

interviews on CBS’ 60 Minutes and with the New York Times.

That has left market participants conjecturing about where Trump might end up, between his campaign threat of “ripping up” the landmark agreement signed by the US and five world powers with Tehran last year, and seeking to renegotiate it.

The implementation of the Iran nuclear deal since January this year has enabled the country to add more than 1 million b/d of supply to the world market.

A new urgency in the Obama administration’s call to Iran to reduce its stockpile of enriched uranium in recent days is being seen as efforts to bolster the nuclear deal ahead of Trump taking charge. The UN atomic agency overseeing the agreement last week admonished Iran for exceeding the limits on its stockpile of heavy water under the agreement for the second time this year, to which Tehran promptly responded by shipping out some of the water to Oman.

It would be worth noting that key Trump foreign policy adviser Walid Phares, speaking just days after Trump’s win, confirmed that the next president intends to “review” the deal and seek some changes, but has no intention of unilaterally rescinding it. Separately, not only has Tehran toned down its rhetoric against Trump since his win, but several of the deal’s opponents in the US as well as within the Israeli leadership are now said to favour strong enforcement instead of pulling the plug.

The situation can change, of course, but all things considered, for now this does not look like a million barrels a day that OPEC could count on disappearing from the market without any effort on its part.

MEXICO STEPS UP 2017 CRUDE HEDGING VOLUME

The Mexican government has increased the volume of oil hedged but lowered the price floor to $38/barrel in its 2017 program, according to an International Monetary Fund report this month. The Latin American country, known for the most transparent and largest sovereign oil hedging program in the world, has been securing protection against its crude export prices falling below the level assumed in its national budget consistently for the past 15 years.

For 2017, Mexico hedged 250 million barrels (about 685,000 b/d), up from 212 million barrels in 2016, by buying put options with Mexican crude Maya and Brent as underlying assets. A put option gives the buyer the right, though not the obligation, to sell the underlying security at the strike price if its market value drops below that price. So far, Mexico has cashed in on its options in 2009 and 2015, and is expected to do so again this year.

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Majornon-OPECproducersoutput* inmilb/d

Sources: OPEC, various news reports

* October figures used where available, the rest are expected 2016 averages

Vol. 1 Issue 14 25 November 2016

The $38/barrel strike price is below the $42/barrel average price for Mexican crude imports the government has assumed for its 2017 budget, with the difference to be covered by the country’s Revenue Stabilisation Fund, if needed. Mexico on average hedged between 210-230 million barrels over 2010-2015, in line with its net crude export volumes. We would like to highlight the move to expand the hedging volume in 2017, which, the IMF paper points out, could also help cover any drop in domestic oil revenues, as the country is gradually moving to fully liberalise its gasoline and diesel markets — expected to be completed by 2018 — from a regulated regime.

While a net exporter of crude — the country exports roughly half its crude production of just over 2 million b/d — Mexico is a net importer of gasoline and diesel.

The IMF suggests that the hedging of domestic product sales could be implemented by state oil company Pemex having its own program, to smooth out the volatility in its revenues.

Several Asian governments, which have taken some bold measures to slash away fuel subsidies and liberalise gasoline and diesel prices over the past two years, may also want to look at encouraging their national and state-owned oil companies to hedge their exposure to volatility in the international markets.

A recently-published S&P Global research paper discusses in depth, the fuel pricing reforms across Asia’s biggest oil consumers, compares their strategies, and suggests a scorecard to evaluate their progress through time and on a comparative basis.

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Disclaimer: Views and opinions expressed here are for information purposes only and not an offer or a solicitation to sell or buy any physical commodities or financial instruments. The views and analysis are based on reliable public information available at the time of writing. This report and its content cannot be copied, redistributed or reproduced in part or whole without the prior written permission of Vanda Insights.

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