March 20, 2017 7:00 pm JST
Vandana Hari

OPEC keeps US shale guessing on cuts -- but the answer is clear

Not extending reductions beyond June would send crude tumbling again

Saudi Energy Minister Khalid al-Falih walked in the footsteps of his predecessor, Ali al-Naimi, at a prominent annual oil industry conference in Houston on March 7 to again deliver a warning to investors in the U.S. shale patch, albeit in a milder tone: Do not give in to "irrational exuberance."

Naimi had tougher words for OPEC's adversaries a year earlier: "Lower costs, borrow cash or liquidate," he told tight oil producers at the CERAWeek conference in February 2016. "It sounds harsh, and unfortunately it is, but it is the most efficient way to rebalance markets," Naimi said. Brent crude was trading around $33 per barrel then, and OPEC appeared to have girded itself for a fight to the finish with U.S. shale, whose production boom had tipped the market into oversupply.

This month, al-Falih's words came against a backdrop of higher Brent prices -- up 70% to around $56 per barrel. That was helped in large part by a well-engineered about-face in OPEC policy, which saw the bloc resume its role as a swing producer, and a historic collaboration with 11 non-OPEC producers, including Russia, to collectively slash nearly 1.8 million barrels per day of crude supply in a bid to accelerate the rebalancing of the oil market.

But OPEC has a tiger by the tail. Despite independent surveys validating its high discipline with the promised 1.2 million bpd production cut in January and February, global commercial oil inventories over that period, to the extent that they can be measured, have not drained as quickly as some might have anticipated.

Tricky target

That makes it highly improbable that OPEC will be able to achieve its target of reducing the bloated crude and refined product stocks -- sitting at more than 3 billion barrels among members of the Organization for Economic Cooperation and Development -- back to their five-year average by the end of June, which is when its current output cut deal is set to expire.

Going by the latest figures from the International Energy Agency, which show an average 1.5 million bpd buildup in OECD inventories through January, a back-of-the-envelope calculation shows stocks will need to shrink an average of nearly 2.2 million bpd between February and June. That is 22% above the collective OPEC and non-OPEC cuts, assuming 100% compliance.

And yet, al-Falih, Russian Energy Minister Alexander Novak and OPEC Secretary-General Mohammad Barkindo in recent days have remained resolutely noncommittal on the possibility of extending the cuts. Their stance, combined with a relentless rise in U.S. crude inventories since the start of the year, finally rattled the confidence of the speculative bulls in crude futures and sent Brent spiraling down 8% to three-month lows during the week of March 6, though it managed to stay above the key psychological level of $50 per barrel.

OPEC is at a critical juncture of its new strategy. It may have won the first battle with a disciplined start to its production cuts, but the organization is in for a trickier and long-drawn psychological war. How can it ensure that crude remains propped up in the $50-60 per barrel range without triggering a resurgence in U.S. production that pushes prices right back down?

Saudi Arabia, OPEC's de facto leader, has gone beyond its commitment by slashing production by nearly 700,000 bpd, or 6.6%, to an estimated 9.8 million bpd in February from the level in October 2016. In doing so, it is leading by example, and partly compensating for some of its peers within and outside OPEC, who are being slower in achieving their target cuts. But the kingdom is also shouldering a disproportionately large burden of indirectly propping up U.S. shale producers, which must be highly unpalatable.

Buoyed by a 20% jump in crude prices since OPEC's Nov. 30 agreement and a positive outlook for the coming months, U.S. shale drillers have announced big spending increases for 2017. ExxonMobil and Noble Energy picked up acreage in the fast-growing Permian region in multibillion-dollar deals in the first two months of this year. Executives of companies active in the Permian, which accounts for a little over 2 million bpd, or 22% of total U.S. crude production, are boasting break-even costs as low as $40 per barrel and a projected rise in output from that region alone to 10 million bpd in a decade if prices hold up.

The U.S. Energy Information Administration earlier this month raised its forecast for 2017 average crude production in the country to 9.2 million bpd, representing a 300,000 bpd increase from 2016. Last year had seen a 530,000 bpd drop from the year before, the first decline after seven years of successive annual increases, as falling crude prices caused higher-cost production in the country to dry up. All of that output, and more, is poised to return now, helped by increasing efficiencies and cost-reductions in shale, but in large part thanks to OPEC.

However, the shale patch is highly sensitive to prices -- and is closely watching OPEC's moves and intentions with regard to the output cuts. Information is key, so OPEC has to play its cards close to its chest.

Deafening silence

What Khalid al-Falih refused to say during his comments both on and offstage at CERAWeek -- whether the OPEC and non-OPEC cuts will be extended beyond June -- was far more powerful than his many cautionary words to shale producers about not expecting "free rides." Novak and Barkindo sang from the same hymn sheet. Deflecting the questions was easy; it is understandable that before deciding on an extension, OPEC wants to evaluate its own ability and that of its non-OPEC collaborators to adhere to production curbs, as well as gauge the impact on inventories and prices from the first six months of cuts. But in this case, not saying much was imperative if OPEC is not to give the game away.

While the official line will probably remain noncommittal, at this stage it is inconceivable that OPEC could abandon its cuts in June and expect prices to hold at current levels. Recent history has demonstrated that producers do not efficiently self-regulate -- those who can will go back to pumping full-tilt, which, in the face of moderate demand growth, could send crude crashing back to $30 or lower. The work of rebalancing could indeed be once again left to free-market forces, but the clock on that slow process would have been set back by a year or so.

Saudi Arabia "does not support OPEC intervening to alleviate the impacts of long-term structural imbalances," al-Falih said in his address at CERAWeek. Hence, the current arrangement is for a limited period, to "accelerate rebalancing, and then allowing the free market to work." The trouble is, free markets set their own course. What was artificially adjusted through market intervention could be easily unraveled if the reins are handed back too soon.

Vandana Hari is founder of Vanda Insights, which provides research and analysis on the energy markets.

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