John Kemp, Reuters

OPEC is sticking doggedly to its plan to cut commercial oil inventories down to the five-year average to rebalance the oil market.

But in doing so the organization risks tightening the market too much, sending prices sharply higher and encouraging a faster-than-expected acceleration in production from U.S. shale producers.

Saudi Arabia’s oil minister, who is OPEC’s de facto leader, has reiterated that stocks are still around 150 million barrels (MMbbl) too high and it would be premature to discuss an exit strategy or change of course.

“Almost the single metric we look at is global inventories and of course the most transparent and trustworthy is the OECD,” he said in an interview before Christmas.

OPEC, the International Energy Agency (IEA) and the U.S. Energy Information Administration (EIA) all have slightly different figures for OECD commercial crude and products stocks, but they show a similar trend.

OPEC estimates that total stocks were about 137 MMbbl higher than the five-year average in October, down by about half since May.

IEA puts commercial stocks about 111 MMbbl above the prior five-year average at the end of October.

EIA data shows commercial stocks 167 MMbbl above the five-year seasonal average at the end of October, down from a surplus of 380 MMbbl in July 2016.

While the specific numbers differ, mostly for definitional and methodological reasons, the data from each of the agencies shows the stock overhang compared with the five-year average has narrowed significantly. Most of the remaining overhang is concentrated in crude oil rather than refined products such as gasoline and heating oil.

Product inventories are already tight in some cases, notably for middle distillates such as gasoil, diesel fuel and heating oil.

Brent Spreads

OPEC seems determined to drive total stocks down to the five-year average, or very close to it, before starting to increase its own output. But that would almost certainly leave stockpiles uncomfortably low, send benchmark Brent prices well above $70 per barrel and push the market into a big backwardation.

Global oil consumption has increased by more 6 million barrels per day (MMbbl/d) over the last five years, according to the EIA.

Other things equal, the oil industry will want to carry significantly higher stocks in 2018 than in 2013 to cover the increase in consumption.

Brent futures prices for the next six months are already trading in a backwardation of about $2 per barrel, which is consistent with a market that is already tight and undersupplied.

The six-month Brent calendar spread is trading about the 78th percentile of its historical range, up from the 22nd percentile at the same point last year. The calendar spread is watched by many physical traders as the most reliable indicator of the balance between production, consumption and inventories.

Backwardation is normally associated with a market that is undersupplied and a low and declining level of inventories, while contango is normally associated with oversupply and high/rising stocks.

The Brent market has cycled regularly between backwardation and contango over the last 25 years as it moves between periods of undersupply and oversupply. The sustained shift from contango in 2015-2016 to backwardation in late 2017 and at the start of 2018 strongly suggests the market has switched from oversupply to undersupply.

Calendar spreads for all months in 2018 have tightened significantly over the last six months suggesting traders see the market moving toward a sustained period of undersupply.

Seasonal Variance

Most forecasters, including the IEA and OPEC, predict the oil market will be in a small surplus during the first-half 2018, followed by a deficit in the second.

The expected rise in stocks during the first half is one reason why OPEC and its allies think market rebalancing will not be completed until later in the year and agreed to keep their output unchanged.

But a seasonal increase in stocks is normal during the first six months, which includes the principal maintenance period for many refineries.

Later in the year, the summer driving season in the United States and winter heating season in the northern hemisphere typically boost consumption in the second half.

Increasing crude stocks during first-half 2018 would only signify a weakening market if stocks rise faster than normal.

Tighten Too Much

History suggests that OPEC will gamble on tightening the market too much, with prices overshooting on the upside, rather than risk not tightening it enough and prices fall back.

After the past two oil market slumps, in 1997-1998 and 2008-2009, prices subsequently overshot OPEC’s formal and informal targets of $28 per barrel and $75 per barrel, respectively.

Front-month Brent futures prices reached almost $35 per barrel in late 2000 and more than $125 per barrel in early 2011.

The six-month calendar spread hit about $4.50 per barrel backwardation in both cases before starting to ease lower.

OPEC has not declared a price target for 2018, though some senior officials from member countries have briefed they want to see a Brent price floor of $60, which implies an annual average well above this. In the past, OPEC members have tended to revise their price targets upward as market prices rise, in a ratchet effect.

Rerunning history, informal price targets, as implied in statements made by officials from OPEC members, have already risen significantly since the start of 2017.

Most OPEC members, including Saudi Arabia, want to see higher oil prices to boost revenues and close their budget and current account deficits.

Saudi Arabia also needs higher prices to finance its ambitious social and economic transformation program and create positive sentiment around the planned sale of shares in its national oil company.

In practice, if OPEC comes anywhere near achieving its objective of draining stocks down to the five-year average level, prices will likely end up well above $70, which will probably be welcomed by most OPEC members.

But the more prices increase, especially with Brent prices near $70 and WTI prices above $60, the more likely U.S. shale drilling and production rates will accelerate, which will tend to frustrate the objective of lowering stocks.