More than seven months into a historic effort by OPEC and some non-OPEC oil exporters to rein in production, the market finds itself in no-man's land.
Benchmark crude prices have been locked in a tight band around $45-50 per barrel in recent weeks, nearly 14% below this year's peak, and fears of a further slide loom larger than any hopes of a climb toward $60. The much-awaited market "equilibrium," which should have come closer with each month of the meticulously orchestrated supply cuts, seems to have slipped beyond reach.
This was not supposed to happen. So, what went wrong?
To put it simply, OPEC has been forced into a stalemate. The 1.72 million barrels per day of collective cuts pledged by 12 of OPEC's 14 members and its 10 collaborators, including, prominently, Russia, the world's largest producer, are being all but canceled out by around 1.6 million barrels of additional daily supply unleashed onto the market by the U.S. and OPEC members Libya and Nigeria.
For OPEC, the surge in US output is a disappointment in terms of being its worst-case scenario, though not a shock. The sharp rise in crude prices following its agreement to curb output at the end of last year was expected to provide a shot in the arm to the U.S. shale industry, which had been struggling as revenues fell and credit tightened through 2015 and 2016. U.S. crude production, around 64% of which is tight oil from the shale plays, was expected to begin recovering this year, after suffering a major drop in 2016, the first after seven years of growth.
The country's independent shale producers are known for their quick responses to crude price movements, ranging from hedging future production in order to lock in favorable prices, to fine-tuning capital expenditures. That they would move fairly quickly was a given. What seems to have caught OPEC off guard was the quantum of surge in U.S. output.
After declining by nearly 560,000bpd in 2016, U.S. production is now projected to climb by around 500,000bpd this year to an average of 9.35 million bpd.
A source of uncertainty
Output from the major shale plays is expected to average around 5.7 million bpd between January and September this year, about 380,000bpd higher than the 2016 average.
A second shock from shale has just started sinking in: U.S. oil production growth may prove resilient even in the face of the U.S. benchmark West Texas Intermediate crude sinking to the low-$40s in June, depths not seen in the past 10 months. The benchmark has recovered from that nadir, but continued to languish well below $50.
The shale producers have been adapting. They added only 12 new oil rigs in July, compared with monthly additions of between 36 and 53 in the first half of this year.
While fewer rig additions were expected to stall the growth of tight oil production, this may not happen. Much depends on what the shale producers choose to do with their "inventory" of wells, essentially spare capacity ready to be turned on in a fairly short time.
The number of these drilled but uncompleted wells, or DUCs as they are known in the industry, has been consistently growing for the past eight months. The DUCs numbered 7,059 at the end of July, according to the U.S. Energy Information Administration. About a third of these were in the Permian, the largest and fastest-growing shale play, straddling Texas and New Mexico. These alone could add more than 1 million bpd when producing at their peak.
The DUC factor makes it impossible to draw a straight line between a deceleration in rig count growth and shale output in the U.S. Indeed, data shows that while the shale producers have continued to add to the DUC inventory in recent months, the pace of additions has slowed. In other words, the ratio of wells being completed and put into production to total wells drilled has risen since May. If there is a sudden rush to complete DUCs, shale would again be in uncharted territory and may face cost-inflation and bottlenecks. Nonetheless, this is another tool in shale's hands -- and a major source of uncertainty for OPEC.
Credibility on the line
The cartel cannot directly alter the course of U.S. production growth. It is, however, entirely responsible for allowing itself to be blindsided by the jump in Libyan and Nigerian supplies.
The two African producers requested to be exempted from OPEC's production cut agreement last November because they were pumping well below their full capacity, owing to disruptions from strife and militant attacks on domestic infrastructure. While making an exception for them at the time was understandable, not provisioning for their return to capacity left a gaping hole in OPEC's market rebalancing strategy -- one that has still not been addressed.
As of July, Libya was reported to be around 473,000bpd above what it was producing on average in October, the baseline month used by OPEC to calibrate output cuts. Nigeria was 133,000bpd higher. Together, these increases nullify a significant portion of the cuts being made by the remaining OPEC members, not accounting for the fact that the two still have room to grow their production.
This does not bode well for the bloated commercial oil inventories in countries belonging to the Organization for Economic Cooperation and Development. These stockpiles are sitting well above their five-year average despite a modest draw in June. The slight reprieve was too little too late for a growing body of skeptics weighing the OPEC/non-OPEC cuts against the increases from the U.S., Libya and Nigeria.
OPEC and its collaborators have held two meetings in the past month, focusing on compliance and urging stricter discipline of the regular quota-busters. Algeria, Ecuador, Gabon, Iraq and the UAE have consistently produced more than their allocations from day one. If driving better compliance is a precursor to initiating talks about deepening the cuts and bringing Libya and Nigeria into the fold, there might still be hope for OPEC's strategy.
Such an agreement, though, would take a lot of time and effort to forge. OPEC needs to move quickly and act decisively. Its credibility is on the line. Again.
Vandana Hari is founder of Vanda Insights, which provides research and analysis on energy markets.