Since the second half of 2014, the world oil market has been on a roller coaster, as excessive global oil supply has proved to be very persistent. Demand growth has been reasonably good, with global growth in 2015 and 2016 above the recent trend line, but growth in supply has kept crude oil inventories rising. After two and a half years, the end of the rebalancing cycle is beginning to come into focus, in part because a temporary return to supply restraint by OPEC has helped bring it forward, but also as the wave of supply growth has begun to wane. What is becoming much clearer now than a year ago is that the end of the rebalancing cycle will 1) leave U.S. shale producers well-positioned for recovery, 2) continue to cause fiscal strains in some of the larger exporters, and 3) leave the world with relatively thin spare capacity, resulting in a well-supplied market but with serious potential for instability.
Pulling forward the rebalancing process
The agreement reached last November by members of OPEC to curtail supply, in a temporary reversal of the decision to forego market management back in 2014, has alleviated what would have been a return to major oversupply in the first quarter of 2017, and thereby accelerated the progress toward a new market equilibrium. Much of the growth came from the major members of OPEC themselves, with Iraq growing nearly 800,000 bpd in 2015 year-on-year during the price collapse, followed by an 800,000 bpd gain in Iranian production in the wake of sanctions relief granted as part of the nuclear deal in January 2016. Saudi Arabia also maintained its production above 10 million bpd prior to the November OPEC agreement, rising as high as 10.7 million bpd in the summer and fall last year. This additional OPEC volume was enough to more than offset the decline in U.S. production, leaving inventories building even with demand seeing healthy growth.
Overcoming their sharply differing individual interests in order to avoid the potential for another drop in crude oil prices into the $30 level per barrel, the OPEC producers have succeeded in cementing a floor under crude oil prices, with West Texas Intermediate settling into a relatively narrow range between $51 and $54 per barrel for most of the period since December, and Brent around $2 to $3 above that. Compliance with the 1.2 million bpd of pledged cuts is far from perfect, as always, with the Saudis and their close Gulf Cooperation Council partners making a disproportionate share of the cuts as some others, including Iraq, only partially complying. By going substantially beyond its pledged cut and telegraphing that move publicly, the Saudis have been very effective in deterring short-selling in crude. The total of the actual cuts is around 1 million bpd, by historical standards a respectable percentage of the total pledges. The promised cooperation from non-OPEC countries is not likely to be delivered as promised, as much of the claimed 558,000 bpd in cuts is just taking credit for natural declines in production on underinvestment due to lower prices. But Oman had reduced production by its 45,000 bpd pledge, and Russia was down over 100,000 bpd in January, but we still expect it to fail to fully implement its 300,000 bpd promised reduction.
The cuts are partially offset by production gains in Libya, Nigeria and Iran, however, which have left the net reduction from OPEC well below 1 million bpd. Nigeria and Libya are not subject to any sort of production cap, given their status recovering from internal unrest which had reduced production. Iran agreed to a cap which was 90,000 bpd higher than their October 2016 level (as reported by the OPEC Secretariat), but recent public statements from Iranian officials have put their current production level higher than the cap.
Not a historic turning point
Contrary to much of the press coverage at the time of the OPEC agreement, this should be seen as a temporary shift in policy, rather than a historic move back toward active supply management. The primary reason for this is the relatively short lead-time required for U.S. shale oil production to return to growth based on price signals. The recovery in U.S. production has proceeded even faster than Eurasia Group had expected, bottoming out in September last year and up by more than 350,000 bpd since then according to our estimates. That rate will slow down, but it illustrates that there is a very strong push-pull relationship between OPEC and U.S. production. Trying to support a price above the equilibrium level, which we believe is in the low-to-mid $60 per barrel level for WTI in the medium term, would not be possible for an extended period due to the ability to accelerate supply growth in response to price signals with approximately a six-month time lag.
Eurasia Group sees a gradual recovery to the medium-term price equilibrium and normal inventory levels by the end of 2018 as the most likely trajectory. Eurasia Group forecasts WTI averaging $53 in the first half of 2017, $56 in the second half and $60 in 2018, reaching $63 by the fourth quarter of 2018. In part, this stems from our skepticism that the Saudis will want to exert a stronger "pull" on U.S. production by extending the OPEC cuts beyond the six-month period which was agreed upon. Saudi Minister of Energy, Industry and Mineral Resources Khalid al-Falih said a couple of weeks ago that he thought the OPEC cuts would not need to be extended beyond the first half of 2017 due to such high compliance. That struck some observers as odd, due to the fact that global inventories clearly will not be down to normal levels by that point. But even with some rebound from OPEC not extending the agreement, inventory draws will continue through the second half of 2017 and into 2018. Trying to do it faster by extending production restraint, however, would "pull" more U.S. barrels out of the ground. That creates a real dilemma, given the recent evidence of recovery.
Even with the market rebalancing within sight of its conclusion at this point, the long-term outlook for exporters heavily dependent on oil revenues has become more challenging. The sharp reductions in the production costs for U.S. shale oil, particularly in the resurgent Permian Basin in West Texas, have lowered our expectations about where the medium-term equilibrium will fall by $10 to $15 since 2015. That is a lot of lost future revenue for other exporters with petrostate economies. Saudi Arabia, with its Vision 2030 reform plan, is beginning to think about how to transform and diversify its economy to adapt to a world of lower prices, but it will be at best a difficult process. Others like Russia also will see long-term pressures from the diminished expectations around oil revenues. Countries with higher-cost production, such as those with deepwater reserves, are looking at diminished expectations for investment in new production. For the developed world, these price levels will be favorable, though even in the U.S. the sharp fluctuations in prices in the past three years have had major impacts on regional-level economies.
Well-supplied, but not inherently stable
While the new equilibrium may be a price level favorable for developed economies, it will not be an inherently stable one. There is not a lot of spare production capacity by historical standards, and after the OPEC cuts are unwound, there probably will be a gradual increase in output, which will thin it out even more. This means that the Saudis will not have the ability to offset volumes lost from a major crisis, such as when they and Abu Dhabi were able to more than offset the entire lost volume from the Iraqi invasion of Kuwait, or when the Saudis were able to facilitate the imposition of harsh U.S. sanctions on Iran by very effectively making up the lost volume. U.S. production may respond to price signals on a much shorter time frame, but it is not a prompt enough response to be considered a "swing producer" in a major supply disruption event.
Iran still a major risk
In 2017 and 2018, the largest risk by far will be the U.S. relationship with Iran under the Trump administration. Eurasia Group does not expect U.S. President Donald Trump to abrogate the nuclear deal with Iran, despite his often stated view that it is a "bad deal." But the sanctions which the Trump administration imposed on Iran as a result of the recent ballistic missile test may be the start of an escalating series of actions by both sides, as Iran continues to probe to find President Trump's red lines. More impactful non-nuclear sanctions could eventually jeopardize the nuclear deal, and it is far from clear how the major world powers which supported U.S. sanctions prior to the deal would react. That question hanging over Iran's export levels will have only a muted market impact for now, but as the market returns to equilibrium, and if things worsen, it could grow.
Greg Priddy is director, global energy & natural resources, at Eurasia Group, a political risk consultancy.