Crude Oil Prices Dip as OPEC Fails to Corral Russia: Update

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UPDATE: A report in The Wall Street Journal indicates that OPEC has now received a commitment from Russian and other non-OPEC producers to continue limiting production through the end of 2018. It is still not clear if Russia will be able to review the extended deal at mid-year and withdraw if it believes market conditions have changed.

The Organization of the Petroleum Exporting Countries (OPEC) has agreed in principle to maintain until December 2018 production cuts scheduled to end in March. The Wall Street Journal reported the agreement citing sources familiar with the matter. That is not, however, what markets wanted to hear.

Crude oil has been trading higher for the past several weeks on the expectation that Russia and other non-OPEC partners in the production cuts would agree to extend the lower production level until the end of next year. Russia has apparently balked, sending benchmark West Texas Intermediate (WTI) crude from an intra-day high of nearly $58 to just a few pennies above $57. Brent futures also dropped about $1 per barrel to trade at around $62.40.

The Russians do not want to commit to an extension through December 2018. The world’s leading producer would prefer to extend the agreement only through June and then return to the status quo ante if market conditions are favorable. The current production cuts have removed about 2% of global supply.

Russia is concerned that continuing the cuts for another nine months will work too well, driving prices to a level that will unleash another wave of investment and drilling in U.S. shale plays, running production higher and, once again, lowering prices. The Saudis are not worried about U.S. shale production because they believe the global market can absorb any increase from the shale producers.

The Saudis are probably right. The United States is on track to reach a production level of 10 million barrels a day this year and to fill the 2% hole in global supply would need to add nearly 2 million more barrels daily next year. That is not going to happen.

What is happening is that U.S. producers are hedging 2018 production like crazy. Bloomberg News cited a report from Wood MacKenzie that new hedging contracts acquired during the third quarter have added about 900,000 barrels a day of annualized production to drillers hedged positions.

Most of the contracts guarantee payments of $50 to $60 a barrel. With prices locked in at that level, producers might decide to drill more. Alternatively, a producer might just decide to leave capital budgets as planned and raise cash flow guidance to satisfy investors seeking some profitability.

If the Saudis and OPEC can corral Russia to commit to a nine-month extension through the end of next year, WTI prices could reach $60 a barrel before the end of this year and stay there. Good news for producers, but not-so-good news for consumers.