By Liam Denning

Jul 2, 2019

OPEC+ is having a debate about time. Esoteric as it sounds, the positions taken would be the difference between stable oil prices and a monumental price spike.Khalid Al-Falih, Saudi Arabia’s energy minister, raised the topic this week of shifting the oil-producer club’s target. Since late 2016, OPEC+ has aimed at reducing the glut of oil inventory weighing on prices. And it’s been largely successful. Crude oil and refined product stocks in OECD countries – the most visible – have dropped from a peak of 3.11 billion barrels in August 2016 to 2.88 billion at the end of April, according to the International Energy Agency. But inventories have risen again this year, and Al-Falih would like for them to drop lower. A lot lower.OPEC+ estimates stocks at the end of May were about 25 million barrels higher than the five-year average.

The problem with the five-year average is that the past five years have been a time of exceptionally high inventory – which is how we’ve ended up with OPEC+ and its efforts in the first place. So Al-Falih suggests targeting a different time period: the average for 2010-14. This, you may recall, was a happier time for oil producers, when Brent crude averaged $102 a barrel, versus today’s $63.Using that figure of 25 million and assuming OPEC+ is talking about the period 2014-18 for its current five-year average implies stocks ended May at about 2.92 billion barrels. That is 222 million barrels higher than the average for 2010-14 (Al-Falih mentioned a figure of 240 million barrels, so this seems close enough).Inventory is just a means of satisfying demand, though. So it matters that global demand has risen by about 10% versus the average level that prevailed in 2010-14, because a barrel in storage today doesn’t meet the same share of consumption as a barrel in storage back then. To truly understand the impact of switching to Al-Falih’s suggested target, we have to look at how many days of demand are covered by inventory. This is measured by dividing the stock-level at the end of the quarter by the next quarter’s demand.On this measure, oil inventory would drop to its lowest level since the summer of 2008, relative to OECD demand. You may recall that prices were a fair bit higher then.

The added wrinkle is that most of the growth in oil demand this decade has been in developing economies. So the chart above likely understates the true impact of cutting OECD inventory back to pre-crash levels. Comparing those stocks to global demand implies an even tighter market if those 220 million-odd barrels drained away:

Suffice to say, targeting a level that would slash roughly the equivalent of a work week from OECD demand cover would be a very aggressive move. On one hand, it’s easy to see why Saudi Arabia would be interested in a harder turn of the dial on its time machine. The government needs higher oil prices to fund itself without continuous resort to deficits. It’s also reportedly reviving plans for an IPO of Saudi Arabian Oil Co., or Saudi Aramco. Even if that’s unlikely to hit the $2 trillion valuationbandied about originally, it would still benefit from a tailwind of higher oil prices. And Saudi Arabia provides the bulk of voluntary supply cuts for OPEC+ anyway, so its views count for a lot.

Like picking a static metric from years ago as a target, however, taking such considerations in isolation from the broader context of the oil market would border on the ridiculous.

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Alexander Novak, Russia’s energy minister, sounded less enthusiastic about the idea in remarks on Tuesday, noting changes in demand ought to be considered. Moscow likes higher oil prices, too, but isn’t quite as needy as Riyadh. Moreover, Russia’s oil companies aren’t thrilled about curbing supply – even the relatively small cuts they contribute to OPEC+ – and Al-Falih’s suggestion essentially implies cuts as far as the eye can see.

Taking demand cover down that far would, all else equal, light a fire under prices – and thereby spark a bigger surge in U.S. shale production and likely deliver a knock-out blow to demand growth, which looks shaky already. Saudi Arabia may well be throwing such figures around merely to nudge OPEC+ toward a tighter target short of such a nuclear option. As I wrote here, though, supply cuts themselves carry an inherently bearish undertone. Even deeper cuts wouldn’t change that and, ultimately, would reinforce it.

With assistance from Julian Lee.