Overview

• OPEC agrees to a substantial production cut. Last week, the Organisation of Petroleum Exporting Countries has agreed to reduce production by around 1.2m barrels/day (bpd). Saudi Arabia will reduce production by 486 thousand bpd while UAE, Kuwait and Qatar will see a combined cut of 300 thousand bpd. Iran, Libya and Nigeria are exempted from cutting production in view of their prevailing economic climate. The agreement will last for six months with options to extend for a further six months based on prevailing market conditions.
• Major non-OPEC members to contribute. The OPEC production cut will be complemented by additional cuts of 600 thousand bpd by other non-OPEC major oil producers including Russia. Russia have committed to a 300 thousand bpd cut though the cut will be gradual within 1H17.
• Initial reactions have seen oil prices rising past the 10% point. In the immediate aftermath of OPEC’s announcement, oil prices rose by as much as 12%. Price for Brent crude futures jumped 13% to USD52.54/barrel as at Wednesday, 0600 GMT.
• Positive impact on Malaysia’s fiscal balance. Assuming oil price sustains at USD50-55/barrel range, we expect Malaysia’s oil-related revenue to rise to RM31.4-RM34.6b during 2017 from the MoF’s initial forecast of RM28.3b (based on oil prices at USD45/barrel). Assuming no changes to expenditure, we expect corresponding fiscal deficit to fall to 2.8% of GDP on higher oil-related revenue with the flexibility of pursuing a more aggressive fiscal expansion should prevailing uncertainties undermine growth.

A tough sell

Cut in production to help drain inventory. OPEC’s stated goal for its present production cut is geared largely towards managing excessive inventories and the supply overhang in the market. Stabilisation of oil prices was not an explicit goal of the production cut. Indeed, oil price above the USD55/barrel mark or in excess of USD60/barrel is likely to be counterproductive, encouraging further expansion of shale oil and reverting oil prices to around USD45/barrel. A sustained oil price around USD50-55/barrel, however, will be a positive catalyst for renewed interest investments in the oil and gas sector. Indeed, price levels in excess of USD55/barrel levels may tempt producers into ramping up production, ultimately undoing OPEC’s proposed efforts.

OPEC announcement as a sentiment booster. In the immediate term, the OPEC announcement serves as a quick shot in the arm for oil prices. As one of OPEC’s most convincing action since 2008, markets have

been upbeat of its impact towards the prevailing global supply glut. However, with the proposed cuts taking into effect only in January 2017, the announcement serves largely as a confidence booster both for the market and for OPEC’s credibility as a market influencing force.

Beyond the immediate feel-good factor. The sustainability of the present oil price rally, at least in the short term, will be contingent on the follow up moves in the run up to January 2017 as details are somewhat scant at present. 300 thousand bpd production cut by non-OPEC members remain unaccounted for. An upcoming meeting between OPEC members and nonOPEC producers to be held within the next ten days (estimated 9 December 2016) is expected to shed more light on this; the agreement may unravel in the absence of a consensus on production cuts. The participation by US (particularly by its shale producers) may also be a key consideration towards evaluating the sustainability of the present oil price rallies. Additionally, participation by other producers, such as Brazil, Canada, Mexico, Norway and the UK may strengthen the momentum for a price recovery. A failure to reach a meaningful consensus at the next meeting threatens to scuttle the OPEC’s initiative at its inception. In the more medium term, the implementation of the production cuts will be in focus. Compliance by the OPEC members and by major non-OPEC producers remains in question. While a Ministerial Monitoring Committee will be established, lag in data transmission and the lack of mandate to enforce these production curbs may limit the committee’s effectiveness somewhat. It is doubtful if the Committee’s mandate covers supervision of production from non-OPEC members. On the demand side, the threat of a softer Chinese economy in 2017 along with a lacklustre economic recovery in the emerging markets limits the upside on oil price recovery. While a resurgent US economy may be supportive of stronger global demand, we expect that the demand will more likely be absorbed by local US shale producers. Overall, we expect demand-based factor as a significant risk in the execution of OPEC’s production cuts.

Implications to Malaysia

Higher oil prices provide much needed fiscal space. Given the current budget estimates assumes a USD45/barrel price, we expect a sustained oil price level exceeding USD50/barrel to go a long way towards the government’s fiscal consolidation efforts. At USD50-55/barrel range, we expect oilrelated revenue to rise to RM31.4-RM34.6b during 2017 from the Ministry’s initial forecast of RM28.3b (based on oil prices at USD45/barrel). Assuming no changes to expenditure, we expect corresponding fiscal deficit to fall to 2.8% of GDP on higher oilrelated revenue with the flexibility of pursuing a more aggressive fiscal expansion should prevailing uncertainties undermine growth.

Oil prices a catalyst for inflation. Our estimate for a 2.8% deficit (ceteris paribus) is also underlined by the assumption that potential cost-push inflation arising from higher oil prices will not be a significant damper on growth. We expect inflation to remain manageable at an annual average 2.3% for 2017, notwithstanding higher oil prices, and 2.1% for 2016. Assuming no significant deterioration in domestic demand, we expect the associated OPR to be maintained at 3.00% in 2017.

Appreciation pressure for the Ringgit? Traditionally, movements in the ringgit have been closely tied to fluctuations in oil prices. A sustained recovery in oil prices is likely to lead to a mild appreciation to the ringgit. We foresee ringgit to trade at MYR4.25/USD by the end of 2017 from MYR4.45/USD by the end of 2016.

Conclusion

A proposal filled with pitfalls. We identify at least two major pitfall-laden time horizons with regards to OPEC’s proposed cuts. Firstly, the period leading up to the implementation of production cuts will be instrumental especially in obtaining greater clarity for the details of the arrangements. The failure to obtain a buy-in from a large swathe of non-OPEC members threatens to strangle the plan in the cradle. Secondly, the periods following its initial implementation will be instrumental in evaluating the compliance of the participants

and other market players, most notably the US shale producers. The plan is also contingent on demand-side considerations, especially with regards to the threat of softer global growth.

Fiscal space to receive a mild support. Assuming that oil prices remain sustained at USD50-55/barrel, Malaysia will see more breathing room either in its fiscal consolidation effort or its ability to stimulate the economy further (in the event of major events undermining growth). Additionally, heightened expectations of a 2017 election may prompt further expansion of fiscal stimulus. In some ways, the present OPEC coordination will be a crucial test of the Organisation’s relevance and credibility against the backdrop of low oil prices. OPEC’s decision on Thursday distinguishes itself in scale, comprehensiveness and its attempt to engage non-OPEC members in managing oil prices.

Source: Kenanga Research - 5 Dec 2016