The oil market is in a holding pattern. It cannot make up his mind which way to go in the immediate future. On one hand last week’s positive progress on the US-China trade talks is still seen supportive. On the other hand, there has been no further development or clarification as what to expect. An update will be provided today when the US President gives his speech about his administration’s trade policies at the Economic Club of New York today. He is widely expected to delay his decision to impose tariffs on European car and auto part imports and will also shed further lights on the status of the trade negotiations with China.

The early travails lower in the oil market reversed course in the afternoon as intelligence firm Genscape reported a draw of 1.2 million bbls in Cushing inventories last week. This depletion is probably due to the Keystone pipeline shut down but no prolonged impact is anticipated. TC Energy Corp said the pipeline has resumed operation at reduced pressure and volumes are expected to increase gradually. By the end of the day the main crude oil futures contracts were 30-40 cents/bbl in the red mainly driven lower by the RBOB contract. The latter lost 238 points on the day with the front-month spread collapsing from +234 points at the beginning of the month to +64 points yesterday and the second month spread actually turning into contango. Weak RBOB could cap any attempted oil price rally in the short-term but the next $5-$10/bbl move will be decided by economic and trade considerations.

How can OPEC cut further?

In Friday’s note we examined one possible outcome of the upcoming OPEC meeting. That is that the most reasonable way for the organization to balance the global oil market in 2020 is to reduce output further. Non-OPEC supply growth will outpace global oil demand growth, consequently the call on OPEC will fall. This impact must be mitigated by deeper OPEC cuts otherwise global oil inventories will not fall. OPEC has shown strict discipline in producing well below the agreed quota with the help of unintentional reduction from two member countries. There are, however, two other OPEC members who have been unwilling to share the burden the rest of the group carries. It was therefore concluded that further cuts can be achieved by making sure that these member states also comply with their quotas. Below we are putting numbers on this theory.

It is worth keeping in mind that the official quota level is 31.591 mbpd for the OPEC-14 and 25.937 mbpd for the OPEC-11 without Iran, Libya and Venezuela. (We still consider Ecuador as part of OPEC for the next two months.) The group’s September output was more than 3 mbpd below quota in the first case and 1.4 mbpd lower in the second case, according to secondary sources. Of course the big deficit is partly due to the cut back in Saudi output that month after the attack on the Kingdom’s oil installations. The latest October production surveys, however, also put output levels well below the agreed ceiling despite the monthly rise in Saudi output.

OPEC’s research group is likely to be looking at the demand for its own oil for next year and its relationship to the current output level. After all, the aim is to balance the oil market and not let global oil inventories grow. The latest estimate puts this call at 29.57 mbpd with the quarterly figures ranging from 30.49 mbpd in 2Q to 29.02 mbpd in 3Q. (The latest projection from OPEC is to be released on Thursday.) If OPEC output matched this demand oil stocks will remain more or less unchanged. If it is lower than the call oil stocks will fall.

OPEC’s Secretary-General sounded upbeat on next year’s oil balance last week by saying that the outlook may have upside potential. It was quickly interpreted that deeper cuts could be unnecessary. This assumption, however, could turn out to be wrong. Current inventories in the developed part of the world are struggling to break below the 5-year average and they are historically high. The target, therefore, must be to tame stock levels. In order to achieve that the producer group will have to produce some 300-400,000 bpd less next year than last month – say 29.30-29.40 mbpd on average. The way to do this without demanding extra effort and commitment from the majority of member countries is to continue the adherence to the present deal and demanding extra compliance from those who are lagging behind. Firstly, Saudi Arabia and its Gulf allies must keep showing discipline and willingness to restrict their outputs below their official quotas. The Kingdom is probably more than willing to bear the extra burden just ahead of Aramco’s IPO. Secondly, the main cheaters must be regulated. Iraq and Nigeria produced around 400,000 bpd over the allocated targets in October, if the surveys are to be believed. If they can and are willing to get their compliance up to 100%the group’s output level would definitely slip below the call and would stand around 29.3-29.4 mbpd.

We must not forget about Brazil either, although it is not entirely clear if it can be counted on. The country’s president, Jair Bolsonaro expressed his wish to join the oil cartel. It was an unexpected development as Brazil has just completed its biggest ever oil auction (it was a flop) and the talk is to ramp production up to 7 mbpd (without specifying a time frame) from the current 3 mbpd. Nevertheless, OPEC would welcome the South American country with open arms as it would mean that the OPEC+ group controls 50% of global oil production. In the unlikely case of joining the organization in the near future and playing by the rules (countries with quotes have reduced their output by slightly over 3%) another 100,000 bpd could be taken off the market.

Purely looking at the available numbers all OPEC can do is to decrease their output next year below the October level if they are serious about reducing stocks. Anything else would send out the wrong message. Since market sentiment is a powerful factor in determining oil prices and sometimes words speak as loud as action the organization has to make sure to provide frequent reminders that they are undeterred in this course of action.