Shale versus sheiks?
U.S. tight oil production will not be sufficient to undermine the effect of the OPEC agreement. A widespread increase in production would require even higher prices over a longer time period

In the fall of 2014, oil prices began a long period of depression. The initial causes of the decline were macroeconomic, and most closely linked to slowing Chinese demand on the back of a broad policy of economic transition begun by Beijing. But it was conscious OPEC policy (or more accurately, Saudi policy) set in reaction to softening prices that kept prices down for so long. Namely, Riyadh refused to cut supply in response to lower demand, setting a new course for policy expectations in the market and potentially ushering in an era of OPEC irrelevance. The recent OPEC deal seemed to reassure some in the market that OPEC was not really ''dead'', and that a new-found appetite for market management among producers may signal the price floor that they had been so desperate to enforce over the previous two years. Proponents of U.S. oil production could also feel hopeful, since such a scenario could end the battering of American shale oil and see a production turnaround. Hope tends to distract from accurate market expectations, however, and macro trends as well as specific national variables are likely to derail a price rally that is based on overestimations of the deal’s real impact.

The reasons for the decline

The agreement to cut the oil #produzione reassured the market, showing that #OPEC continues to exist

It is useful to start with how we got here. The reasons for the 2014 Saudi decision were multiple, and as with many top-down policy decisions, they were perhaps more parochial than analysts looking for grand strategic narratives tend to presume. Indeed, the rise of American light-tight oil (LTO, or shale) was the result of prices high enough to support this relatively expensive process, and Arab producers watched resilient U.S. rig counts with some interest through 2015. But rather than ''shale versus sheiks'', the U.S. was not, as it is perhaps inclined to see itself, the primary focus of foreign economic policy thinking. Often it is useful to presume the most straightforward and myopic of intentions for bureaucratic policy change. In this case Riyadh looked around the OPEC table at its partners and remembered the early 1980s. Why should it shoulder the burden of so much lost revenue from a production cut, especially if partners were unlikely to follow in good faith, and if in addition, the move 30 years ago failed to bolster prices, leaving the country with a low price, diminished market share, and a dangerous budget shortfall? It was something of a bonus that lower prices would do nothing to help Tehran as it sought to revive production and its wider fiscal fortunes. And so prices fell. Players in the commodity markets were too eager in 2015 to call the price floor, repeatedly pointing to relatively inconsequential or short term data points as an excuse to rally. Those rallies were predictably short-lived. LTO production came under pressure, but the uniquely fractionalized collection of often small producers were tenacious at finding opportunities for cost-cutting, mostly by squeezing service providers, but sometimes with genuine technical innovations and efficiency improvements. The unusual availability of liquidity from financial markets also allowed them to hold out longer in the hope of a turnaround, and hope is a powerful influence when a couple of rigs are the basis for one’s entire small business and livelihood. Eventually, though, even those measures were not enough, rigs were shut down, and despite a budget shortfall Saudi Arabia seemed determined to stay on course. Changing political winds in Riyadh after the death of King Abdullah in January 2015 reinforced the impulse to stick with the strategy, as a young clique surrounding Mohammed bin Salman (MbS), soon to be Deputy Crown Prince, saw an economic future for the kingdom that did not rely on oil. The brunt of market forces was good political cover for subsidy reform and the wider economic transformation program to come.

Assessing the real impacts of the deal

Fast forward to December 2016, and the OPEC deal. Khaled al-Faleh had been elevated from Saudi Aramco CEO to Minister of Energy and Industry, rather than simply of Oil, and the ''Davos man'' face of the Saudi reform effort. The market’s confidence in his judgement is testament to his relatively rational and non-ideological approach to economic management, oil prices, and the market itself. Against the background of unfolding competition in the Middle East among rival power blocs, al-Faleh was shrewd enough to see an opening for cooperation with 11 non-OPEC producers and with Russia in particular. The optics of unity among OPEC members and non-cartel partners could bolster confidence in Riyadh’s continuing influence, with limited impact on Saudi revenues or market share. An earlier effort at production freezes within OPEC had quickly been seen for the ruse that it was. Producers who could were mostly pumping flat-out already, and a freeze would lock out Iran and Iraq, whose production and export capacities were recovering despite low prices. The new deal seemed more genuine, with exceptions for Iran and Iraq, and a buy-in from Russia. The market responded accordingly, and the price rally has been more robust than any other in the past two years. Judging the deal’s longer-term price impact, however, requires looking at the deal’s impact on the real oil economy. That means two main factors. First, in the past, real oil flows were often only marginally affected by such deals due to non-compliance and exceptions. Iran and Iraq, as well as Nigeria and Libya, continue to raise production because of their opt-outs. As for the others, early indications from tanker watchers were that export volumes from non-Saudi Gulf producers were not changing, and were evidence of the usual cheating. More recent analyses offer data to counter that presumption. A late January Reuters survey found 82 percent compliance with output cut pledges, well above the 60 percent compliance rate of the last effort in 2009. The accuracy of the Reuters data is based on shipping data analysis, but also on self-interested sources like oil companies and OPEC itself, and should be taken with a grain of salt. No matter the precise compliance rate, Riyadh continues to dominate the reduction figures in practice, and al-Faleh has predicted that global oil inventories should return to their 5-year averages by mid-2017. That is probably optimistic, but such expectations about commercial stock draws can underpin short-term price gains anyway, with implications for the second factor - how those price gains affect production. The impact on renewed production of the price rally kicked off by the OPEC deal matters - and that depends on dynamics within the U.S. LTO sector. That sector has evolved over the past two years, and there is reason to believe that production is unlikely to snap back once a certain break-even point is reached. Consolidation has meant fewer players in the sector, with diverse well portfolios representing a wide range of production costs, within and among different oil fields. As price rises, these larger players will be more cautious about restarting operations, and will begin with lower hanging fruit, particularly given uncertainty about prices further into the year. Rig counts have indeed increased in the U.S. in January, and that has led to concern about whether American production could drown out the gains of the OPEC deal. But a robust rig count is so far a limited story about the Permian basin, and uncompleted wells that can be brought on cheaply and quickly are only a portion of the greater collection. Significant new production in Bakken and Eagle Ford will need sustained prices at something north of 60 dollars. In short, stickiness and a jerky price elasticity curve make U.S. production responsiveness uneven and less dramatic than simple headline numbers may suggest.

In January, the number of oil rigs has increased in the US and now concern that US production could undermine the achievements in terms of oil prices

Trump and other market unknowns

Oil prices in 2017 and beyond will depend on much more than the OPEC deal and its immediate effects. It seems impossible these days, despite one’s most desperate efforts, to avoid talking about Donald Trump. The perennially vague policy agenda of the new American regime does not lend itself to much nuanced analysis, and when it comes to energy so little is known that much beyond reading tea leaves is just speculation. But the broad outlines already point to the scrapping of regulations and an increase in tax incentives, both of which seem likely to increase U.S. production. However the lag time for new conventional production (say on federal lands) is several years, and it is unclear whether there will be appetite for large new projects in difficult terrain such as the Arctic in such an uncertain price environment. More generally, however, U.S. production should stay robust given slowing legacy decline rates as well as new wells in West Texas. All of this could portend a balanced market quite a bit later than mid-year, and even in 2018, keeping prices reined in. The real price spikes are likely to come further down the road, perhaps in 2019. Upstream investment hasn’t been sufficient to keep up with conventional field declines, and shale oil will not be enough to offset that in the short term. On the demand side, low prices over the past two years have done little to spur extra demand or to kickstart economic growth. China continues to experience large overhangs in its manufacturing capacity, indicating suppressed growth rates to come, and concerted government efforts to reduce smog will put pressure on Chinese demand. A stronger dollar also continues to put downward pressure on oil demand globally. A strong dollar and expectations of American economic growth both depend on how the market responds to Donald Trump’s erratic governing in 2017 - and a trade war could certainly put both elements at risk along with U.S. oil demand. Finally, while fundamentals are key to the direction of the oil price, market positioning can also play a role. At the moment, traders and institutional funds have a pronounced bias toward long positions, and with so many buyers in that position, any beginnings of a reversal will cause a rush to exit. This ''crowded trade'' dynamic has been borne out in the past, and seems to presage a price correction in the coming months.

A long-term prospect

Looking forward, price volatility is likely absent an effective swing producer , and shale oil will not play that role effectively. If previous experience serves as a guide, the industry is likely to experience more dramatic boom-bust cycles over shorter periods of time. Despite the American shale revolution, oil production is set to become increasingly concentrated in a few OPEC producers. Output growth among OPEC countries is led by Iraq and Iran, but both countries face major challenges: the risk of instability in Iraq, alongside weaknesses in infrastructure and institutions; and the need in Iran to secure the technology and large-scale investment required for expansion. The International Energy Agency (IEA) estimates that $630 billion in annual upstream oil and gas investment - the total amount the industry spent on average each year for the past five years—is required just to compensate for declining production at existing fields and to keep future output flat at today’s levels. The current overhang in supply should give no cause for complacency about oil market security. The potential for a price spike by the end of the decade is predicated on fundamentals in conventional oil production and investment rates. The onus will be on oil companies to develop flexible project management to be more responsive to price. Price volatility itself could also have impacts on consumer behavior, incentivizing widespread hedging among industrial customers and pushing individuals to consider alternative modes of transport as electric and autonomous vehicles become more widespread. However ''peak demand'' is a far-off prospect.

A sign of change

The OPEC deal has been a sign of change, in that producers seem keen to re-engage with market management. However the deal and its implementation are not game changers themselves. Compliance seems better than expected, but it remains to be seen whether that continues. The U.S. LTO landscape is a varied one, and a widespread ramp up of shale production will require prices that are higher than today’s for a sustained period. In all, supply and demand trends point to continued market softness in 2017 despite the OPEC deal. While that agreement may have helped to shore up the oil market, bearish factors remain. The real crunch will come later in the decade.