The biggest problem with last November's landmark agreement among OPEC and some major non-OPEC oil producers to reduce output is that it lacks a clearly defined measure of success. The world's inventory overhang has persisted through the first six months of supply restraint under the deal.
Keeping benchmark crude prices in the $50 to $60 a barrel range -- which has been described as desirable by OPEC ministers, though not formally adopted as a target -- would be an obvious achievement. But Brent in early June slipped through the $50 mark and has languished there through most of July. Saudi Arabia, the chief architect of the production restraint deal, remained conspicuously silent through crude's downward spiral, while Russia, the de-facto leader of the non-OPEC bloc of collaborators, signaled it was not in favor of responding with deeper cuts.
A rise in crude prices resulting from restrained production is supposed to more than offset declining sales volumes, a fundamental trade-off for any producer agreeing to join in a coordinated action to cut output and an important criterion for continued quota discipline. This rationale now stands on shaky ground.
OPEC's reference basket, an average price of 14 crudes representative of its members' production, fell to a seven-month low of $45.21 per barrel in June. Using this as a proxy for oil sales revenue, the group's 11 members curtailing output were collectively poorer by around $7.7 billion in June, losing some $257.4 million a day versus December, the month before the supply reduction deal took effect.
Ecuador, a small OPEC producer, has announced its decision to renege on its pledge to cut output by 26,000 barrels per day because it needs to address its fiscal deficit. Kazakhstan, meanwhile, a non-OPEC oil exporter, has said it wants to gradually exit the deal a month or two after March, when the agreement is set to expire. Even if these moves do not unravel the entire production restraint agreement, OPEC can no longer count on full adherence as a measure of success.
OPEC's officially stated goal -- to bring global oil inventories in countries of the Organization for Economic Cooperation and Development to within five-year average levels -- would be a signpost along the way, indicating that supply is coming closer to matching demand. But it should not be confused for the finish line.
Assuming that OPEC and its collaborators can hand back the reins to market forces to maintain an equilibrium and go back to pumping full tilt as long as stocks have dipped below the five-year average mark would be delusional.
In any case, that signpost has so far remained elusive, as increasing U.S. shale output as well as production in Libya and Nigeria -- OPEC members exempt from output cuts -- now counters nearly three-quarters of the 1.72 million barrels per day of pledged cuts under the agreement.
A proactive market-management strategy demands a commensurate and quick response to any substantial and sustained increases from Libya and Nigeria, but OPEC chose to drag its feet on this issue over the past months. Even if the two countries agree to a production ceiling in the coming weeks, they are not expected to concede to a reduction, so their current incremental supply would potentially continue flooding the market.
If OPEC's secret measure of success is to rein in U.S. shale producers and arrest their bounding production growth while aiming for crude to remain in the $50 to $60 range, events so far this year have established that these two goals are incompatible.
The bigger question now is whether the price for benchmark West Texas Intermediate crude -- which has remained in the low- to mid-$40s since the second week of June, nearly $10 a barrel below its year-to-date high -- would crimp the U.S. shale sector's investment and output.
A smaller number of weekly additions of oil rigs in the U.S. through July and a slightly slowing pace of growth in the country's crude production have grabbed the market's attention. But these trends are still a long way from erasing the gains of more than 800,000 barrels per day since October, the baseline month of production that OPEC is using to calibrate its cuts.
The U.S. Energy Information Administration believes the healthy cash flows at shale producers resulting from lower costs, higher productivity and increased hedging -- which has seen future production sold above $50 per barrel -- will sustain growth in output even with WTI price below $50.
This would suggest more of the sub-$50 environment in the weeks and months ahead, unless Nigerian and Libyan flows are disrupted in a big way.
It would be futile for OPEC to wait for the highly unlikely event of U.S. production reversing course into a decline. Even the first signs of such an occurrence would send crude spiking and the shale drillers returning in full force fairly quickly. While the precise break-even costs of the shale basins might be debatable in a constantly evolving environment, the nimbleness of the sector is not in doubt.
This leaves OPEC with two equally difficult options: to deepen its cuts or to make peace with crude lingering below its desired price range.
A third possibility is for the producers' group to continue believing in its mantra that only patience is needed for OECD stocks to ease back. This would be a milestone should it come around, not the final destination, and not necessarily a harbinger of higher prices.
Vandana Hari is founder of Vanda Insights, which provides research and analysis on energy markets.