There were sceptics aplenty when the Organization of the Petroleum Exporting Countries (OPEC) and non-members of the oil cartel announced their historic agreement to cut oil production on 30 November. Two months on, OPEC had reached compliance with its proposed oil output cuts – although Saudi Arabia has now announced it intends to add an extra 200,000 barrels per day (bpd).
As for the non-OPEC countries, only 66% of the agreed cuts have been completed. The shortfall comes from Russia, which cut 117,000 bpd versus the promised 300,000. We never expected Russia to cut the whole amount early on as the high water content of their wells prevents idling of these in the winter months due to the risk of freezing and cracking equipment. Closer overall compliance is expected as and when the weather thaws.
However, there have been two unforeseen events that have mitigated efforts to draw down inventories.
The first is that Mother Nature has reduced demand by approximately 20 days’ worth of OPEC supply cuts. Current conditions aside, this winter has been unusually warm in the US. In fact it has been so warm that heating oil demand is down 18% this year compared to the 10-year average.
US shale production is coming back stronger than OPEC expected.
The second is that US shale production is coming back stronger than OPEC expected. Many of the US oil companies that went bankrupt last year never closed but were bought by private equity firms and subsequently restructured. Additionally, negative sentiment from bond investors toward oil producers has rebounded. As a result, oil companies are no longer reliant on borrowing at 25% private equity rates, but now have access to rates of 5-6% in bond markets.
Shale-rig counts have increased 90% since their lows in May 2016. While the total rig count remains 60% below the June 2014 high of 1,600 rigs, productivity has increased enough to require an adjustment for a fair comparison. When an adjustment for the increased productivity is taken into account, rig counts are only down 10% from the June 2014 highs when oil was US$106.
Regina Mayor, the energy head at KPMG, recently said “almost every shale basin is economic in the US$35-50 range”. The effect is noticeable; we have yet to see significant stockpile reductions and US crude and distillate stocks remain 228 million barrels higher than 2014 levels.
OPEC had been controlling the oil market with a deft hand since the 30 November agreement, keeping the oil price in a tight range around US$55 with judicious comments. But as the reality of weak demand and supply increases outside the group took hold, they now fear a repeat of the effects of cuts made in the 1980s. Early in that decade OPEC cut production with the goal of raising prices, only to have other countries fill the gap of missing supply. The net effect was not higher prices but reduced market share for OPEC. In 1985, Saudi Arabia reversed course and produced at maximum capacity, ultimately driving prices down to just US$7 per barrel, forcing more expensive competitors’ production offline.
Saudi Arabia has announced they have increased production to 10 million bpd, which was the level agreed on 30 November. But the country will no longer reduce production by an additional 200,000 bpd in order to make up for Iraq, UAE and Venezuela who have not cut by the fully agreed amounts.
Where we go from here is dependent on a few outstanding issues.
Global economic indicators are rising, but global oil demand is not.
Global economic indicators are rising, but global oil demand is not. Demand should rise with a lag but some estimates of a 1.5 million bpd demand increase in 2017 seem overly optimistic.
Libya and Nigeria, which were carved out of the 30 November agreement, have increased production since last August. Libya has added almost 500,000 bpd in that time, but suffered a recent security setback at two ports, which threatens to reduce supply. It is likely the situation will stabilise in Libya and Nigeria and that supply will increase in these two very fragile economies. Even in troubled Venezuela, state-owned PDVSA recently held talks with Schlumberger CEO Paal Kibsgaard to “resolve outstanding issues”. Can increased production be far behind in this country that tops the list of both the Economic Misery Index, and the world’s largest oil reserves?
Given this partial retreat by Saudi Arabia, we have lowered our base case for oil by US$5 per barrel, to US$40-55. We will rethink that move if demand increases appear or supply disruptions increase. On 25 May, OPEC will meet to discuss extending the cuts past the preset June expiration. One thing is for sure, with the initial public offering of state-owned oil giant Saudi Aramco planned for next year, it’s going to be a dramatic meeting.