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Economy

Vandana Hari: The oil market looks set to rebound in 2017

The deal to cut output by OPEC and non-OPEC producers is a plus, but will it hold?

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Russian Energy Minister Alexander Novak, left, and his Saudi counterpart, Khalid al-Falih, leave a news conference after an OPEC meeting in Vienna on Dec. 10.   © Reuters

The new year will dawn on beleaguered global oil markets bearing a lot of hope, but it also brings trepidation on account of unprecedented make-or-break changes in the world's oil supply, trade and consumption ecosystem.

The crude price slump of the past two and a half years, amid an unrelenting supply glut, has eroded the profitability of oil companies, shrunk the sovereign wealth of the rich oil-exporting economies of the Middle East, and sent the poorer ones such as Venezuela and Nigeria hurtling into recession. But 2016 is ending on an upbeat note for producers, with crude prices nearly double their January nadir below $30 a barrel.

OPEC's decision on Nov. 30 to lower crude output by around 1.2 million barrels per day, followed by a commitment by a group of 11 non-OPEC producers, including Russia, on Dec. 10 to reduce their supply by a collective 558,000 barrels per day starting in January, has stoked optimism that the oil market will be actively managed back into a supply-demand equilibrium in the first half of 2017. Benchmark crude futures rocketed 20% in response to the two production cut agreements in just two weeks, though they were subsequently weighed down by a spike in the dollar to multiyear highs after the U.S. Federal Reserve raised interest rates by 25 basis points on Dec. 14 and flagged the possibility of three more hikes in 2017.

IFS AND BUTS OPEC's first production cutback accord in eight years, a diplomatic coup in the face of major internal friction, and non-OPEC producers agreeing to collaborate for the first time since 2001 were the oil market's equivalent of the political shocks of Brexit and Donald Trump's win in the U.S. presidential election.

If these efforts succeed in removing 1.8 million barrels per day of crude supply, the world could be 600,000 barrels a day in deficit in the first half of 2017, bringing forward market rebalancing from the year-end, according to the International Energy Agency.

But that is a big "if." Given the fierce battle for market share between OPEC producers over the past two years, and their history of overproducing after output cut deals, the market is expecting only 50-60% compliance. The fact that several OPEC members progressively boosted output up to and beyond the Nov. 30 agreement means the cartel's new 32.5 million barrel a day target only sets the clock back to its average for the first quarter of 2016.

The fact that the agreement between OPEC and non-OPEC producers has a time frame of only six months, coupled with expectations of higher prices prompting a gradual rebound in shale oil output in the U.S., was reflected in prices for near-term crude deliveries spiking much more than those for later months.

And yet, the one overarching lesson from developments on the global stage in 2016 is to expect the unexpected. If the world's two largest producers, the Saudis and the Russians -- who brokered the historic deals at the highest levels of political leadership -- keep their promise, they alone could remove nearly 800,000 barrels a day from the market.

Saudi Oil Minister Khalid al-Falih underscored his resolve by saying the kingdom could make even deeper cuts than the 450,000 barrels a day implied by its new "quota" of around 10 million barrels a day versus its November output. Prices above rather than below $50 a barrel would be far more desirable for the Saudis as they start laying the groundwork for a 2018 international public offering of their crown jewel, state oil behemoth Saudi Aramco.

BEYOND OPEC Russia has been hurting since 2014 due to sanctions imposed on it for its annexation of Crimea, lower oil revenues and a collapsed ruble. Nevertheless, it enters 2017 not just far more relevant to OPEC and non-OPEC market management efforts, but also with major new cross-border alliances. State-owned Rosneft has gained a toehold in the lucrative Indian downstream market with its multibillion dollar purchase of a 49% stake in private refiner Essar Oil, close on the heels of selling stakes in its Russian oil fields to a group of Indian oil companies. The Essar deal also strengthens Rosneft's ties with commodities trader Trafigura Group, which bought a 24% stake in the Indian refiner.

Russian President Vladimir Putin and Rosneft chief Igor Sechin closed out 2016 by notching up an even bigger victory with the sale of a 19.5% stake in the company to commodities trader Glencore and Qatar Investment Authority for 10.2 billion euro ($10.6 billion). That deal boosts the trading relationship between Rosneft and Glencore.

In the U.S., president-elect Donald Trump's choice of Exxon Mobil CEO Rex Tillerson, known for his close ties with the Kremlin, as secretary of state, could bring Russia further in from the cold, though with Moscow unlikely to yield on Crimea, it remains unclear if the U.S. sanctions against it will be lifted anytime soon.

Russia, along with Brazil, a major and growing oil producer, may emerge from recession in 2017, thanks to recovering oil prices, according to an OPEC analysis.

While 2017 may well be the third year in succession that spending for oil and gas exploration dives, countries such as Brazil, Mexico and Iran are looking to revitalize their upstream sectors by offering better terms to foreign investors. Mexico, having implemented landmark energy reforms this year, awarded eight exploration blocks in its first deep-water bidding round to 12 global and national oil companies in December. Brazil is slated to offer promising blocks to foreign investors for the first time in 2017, after liberalizing offshore industry regulations in 2016. Iran, keen to rev up its oil industry after years of Western nuclear sanctions, launched the first tenders for oil and gas field development under a new, more flexible and attractive upstream contract model for foreign investors.

If the production cuts succeed in stabilizing crude in OPEC's desired $50 to $60 a barrel range, U.S. shale will be under the lens for signs of revival. A combination of increased producer hedging, as well as possible tax reductions and an easier regulatory environment under the Trump administration could propel U.S. crude production from survive to thrive mode. America under Trump next year could also diverge from the rest of the world, where the COP21 carbon emissions commitments are adding to pressure on oil companies from shareholders, investors and financial regulators to quantify and tackle climate change-related risks to their businesses.

A bigger transition looms in the background -- that of a secular decline in global oil demand. With expert projections putting peak world oil consumption in a wide range between 2020 and 2040, how can the industry prepare? It has to become one with the disruption.

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

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