In November of 2014, OPEC delivered a sizeable blow to oil bulls still hoping for the organization to pull the market out of a tailspin. The decision to leave production unfettered by targets, quotas or any other constraining mechanism caused a sharp five dollar plus price drop that day, en route to an eventual low point in early 2016. The decision was driven in large part by Saudi Arabia, which felt it could not successfully contend with surging non-OPEC production after years of high prices. U.S. shale was a big part of this, but the role of Canada and others, as well as relatively weak demand, were also recognized. In the first six months, the policy helped to boost OPEC production by nearly two million barrels per day (MMb/d), while shale only belatedly began falling, after gaining nearly 300 kbd from November to April 2014. The delayed fall in U.S. production served to highlight the concern within OPEC that a production cut would only be replaced by production elsewhere, causing total revenues to fall from both components, price and volume. The policy to let OPEC production go where it would was based on the view that volumes were controllable while global balances (a stand-in for price) could not.
The conditions that led to an agreement
The route between the November 2014 decision and the agreement that both OPEC and non-OPEC countries reached in late 2016 was paved with multiple bilateral and group conversations, a willingness to compromise, and changes in the market. These changes stemmed from four conditions:
-Shale as a threat. In 2014, U.S. shale production grew more than all global demand, an untenable position for stable prices. Since the price fall, the cost cuts, reduced production and perceived slower response time have all contributed to the belief that shale will no longer grow at a level that is unsustainable for the global system.
-OPEC production growth. It is difficult to gain an OPEC cut, or even a freeze, when one or more countries is still growing strongly. This was the case for Iraq and Iran as production grew for different reasons and at different time intervals between the key 2014 and 2016 OPEC meetings. As each hit its zenith, the barriers to an agreement were reduced.
-Sharing of cuts. Many were expecting or at least hoping that Saudi Arabia would shoulder the burden of the cuts in late 2014 at the beginning of the price decline. But the Saudis saw little advantage in taking on all the pain of a production cut while the benefits were socialized. Sharing cuts across eleven OPEC members and several other non-OPEC producers allowed the OPEC core to contribute substantial volumes (~800 kbd) while benefitting from cuts elsewhere.
-Falling prices. The reduced oil price has dented the financial situation of all OPEC member countries to one extent or another. But a falling price has also caused many to behave tactically rather than strategically as they stayed focused on maximizing revenue in the degrading price environment. The talk of a freeze at Doha and then a final delivered deal helped to boost prices nearly $25/b over the course of the year, more than sufficient to persuade countries that a production cut was not only possible but could increase overall revenue.
Early data suggests that compliance in the early part of the agreement has been very high, with some assessments showing a level above 90 percent. The 1.2 MMb/d cut of the OPEC communiqué was quickly followed by another 600 kbd cut pledge by non-OPEC countries. The OPEC cut paid for itself and gave a return the same day as the announcement. The non-OPEC agreement, made several days later had a similar effect. The physical impact of the cut, which the public reporting agencies largely took at face value as announced, was less certain, though none thought it would immediately reverse the 10+ quarters of oversupply into a deficit. While most of the price impact occurred before the agreement—the forward curve began to dip back towards backwardation after the agreement—a condition suggesting tightening fundamentals, and with it the beginnings of the release of a portion of the 1.3 billion barrels of accumulated crude and products since the price rout began. The capacity of the OPEC organization to strongly rally around an agreement as well as extend its influence beyond its members causes some pause that perhaps the oft-forecast "Death of OPEC" is not only wrong but that the group is on the verge of new relevance in balancing the global oil market. The market is changing and OPEC is changing with it, but there are several reasons this strong compliance level is likely to be a high-water mark as OPEC’s power again recedes and it continues to remake itself in a market vastly different than what existed even in the hey-day of shale’s boom time.
Risks to OPEC's current high cut compliance are multi-fold : the first risk is external to the organization, as shale has already shown a quick uptick in activity, with horizontal and directional rigs up more than 125 units in the 10 weeks after the OPEC agreement
Risks to OPEC’s current high cut compliance are multi-fold but stem from the issues set out above. The first risk is external to the organization, as shale has already shown a quick uptick in activity, with horizontal and directional rigs up more than 125 units in the 10 weeks after the OPEC agreement. Shale activity responded rapidly during the price slide as companies cut costs, reduced the rig count, focused on the core areas and increased efficiency. These steps have allowed average productivity per well to more than double for most plays since the price fall. But overall shale production dipped slowly from the price shock. The incentives of shale producers towards prices is asymmetric, as they have struggled to maintain production in the face of declining capex, they will be able to hold onto some of these gains permanently, upwards of 60 percent. This increases the risk that the price uptick will sharply boost U.S. production. Most estimates of 2017 production growth range from 0.3 to 0.8 MMb/d, and the necessary return of drilling to non-core areas will counter some of the efficiency gains, but there remains the possibility that a sufficient price signal could return the industry to a time when analysts were woefully under-forecasting shale growth for several years running. The second risk is from inside OPEC itself. Libyan and Nigerian production have been hampered by different forms of internal strife with Libya also managing some maintenance issues that hampered production in the latter part of 2016. Libya production has risen from the erratic but low levels of 200-400 kbd to more than 700 kbd in early 2017, with a plan to increase to 1.2 MMb/d, enough to offset much of the OPEC cut and extend the oversupply for another 2-3 quarters. There are several hurdles to overcome as this production level rises amid higher oil prices. The potential to double or triple oil revenues year over year will put pressure on an Egypt still emerging from the weak state capacity that became entrenched over decades of rule by Muammar Gaddafi. As revenues rise there is risk of a strike, unrest or other issue, all of which could swiftly reverse production gains in the country. While Libyan outage risks increase as prices increase, the opposite is true for Nigeria. The range of outcomes is smaller for Nigeria than Libya, with a production recovery of up to 300 kbd near the maximum of its production. The higher prices and revenue as well as the anti-corruption campaign of President Buhari hold the potential for more revenue to be available to the Niger Delta states. This could reduce unrest and outage risks. Nigeria and Libya are part of OPEC but were exempted from the organization production cuts. However, their production levels, likely to be higher than last year even with the risks, make it harder for OPEC to deliver the needed production cuts for the global balance.
If member states don't stick to their promises
Risks also come from the potential for members to increase production in the months to come. The December 2008 agreement in Oran, Algeria to cut more than 3 MMb/d from OPEC production also had its best compliance in the first few months after the agreement. The OPEC core met its agreed-to obligations by cutting more than 1.1 MMb/d, a compliance level of more than 100 percent. The other seven members also cut by a similar amount, but this was only about half of what they agreed to do. Venezuela only cut about 100 kbd after agreeing to cut nearly 650 kb/d and was a large part of the missed production cuts. The OPEC core, both individually, and as a group, maintained its obligations over the next year while the other members saw its compliance fall sharply to only about 23 percent of the agreement. The most recent OPEC agreement is seeing a similar pattern in the early data, with some countries, particularly in the OPEC core, cutting more than was agreed to in Vienna. As time extends into this initial six-month agreement there is a higher and higher likelihood of some members seeking to regain some of the "lost" revenues from lower production. This is likely to also be true for non-OPEC countries, who are unaccustomed to cutting production and also suffer from weakened oil revenue. This temptation to reduce compliance will rise over time but should the oil price retreat further verbal entreaties by OPEC ministers may fail to rally the market as it did time and again in 2016. There is a potential that OPEC is able to hold the line across the board this time. On the surface, there is even an argument that can be made that its market power is at a maximum given the agreements extend to cover several non-OPEC countries. But maintaining this stance will take several elements given OPEC has no punitive authority. The first is countries will need to clearly see the financial upside in adhering to the production cut. Even in a rising price environment this will prove tough, and the free rider issue will likely cause countries to no longer see the incremental revenue upside from the initial cut, instead focusing on the lost revenue from reduced production levels. Even if the cohesiveness of the broader group is maintained, the group must have the largest, and most flexible volumes of all the elements available for market balancing. U.S. shale is not a party to the non-OPEC agreement, and despite the history of the Texas Railroad Commission, it is unlikely to join in anytime soon. Shale has already shown its ability to be a disruptive force in global markets after upending the supply-demand balance in 2014. These fast moving volumes are not sufficient in either size or speed to balance the market on its own in short order, but they are of sufficient size to undercut efforts by OPEC or a broader OPEC/non-OPEC coalition to balance the market. The market balancer is not a battle between OPEC and shale. The reality is much more complex, and should include the growing importance and volumes of stored oil in the market balance. The oil market is moving from the uni-polar market balancing world of OPEC to a multi-polar world of several balancers that can shift barrels at different points on the time scale and at different price points.
In a market consistently oversupplied, it can be forgotten that for OPEC to recapture its prior status, it must also be able to flex production up as well.
The market will not easily return to a "new normal"
In a market consistently oversupplied, it can be forgotten that for OPEC to recapture its prior status, it must also be able to flex production up as well. The low prices have sharply reduced capex spending for companies, and capex for exploration is back at 2006 levels. This is only one harbinger of a potential shortfall in supply in the future, and OPEC at this point is ill-equipped to accommodate any dramatic increase in the call on OPEC given the increased production from the organization over the last two years has come at a cost of reduced spare capacity. OPEC’s cut of November 2016, along with the subsequent agreement by non-OPEC to also cut production, provided a boost to prices and helped pull forward forecasts of when the global balance would again emerge. But the oil market of today is different even from that of 2014, with the ongoing issues of OPEC such as the free rider issue and low spare capacity continuing to reduce the overall effectiveness of its long-term market management capabilities. Producers have benefitted from the heroic action taken but should be cautious in believing that the market will now return to a "new normal." The market and the roles of new and existing players is still evolving, and OPEC is unlikely to step smoothly back into its old role.