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Commodities

OPEC needs more than disciplined cuts to chart new course

US shale means continual tweaks, broader cooperation crucial for market stability

OPEC must reckon with a resurgence of U.S. shale oil as it attempts to fine-tune crude output levels.   © Reuters

OPEC has embarked on its promised crude production cuts with an unprecedented degree of adherence, keeping the benchmark Brent trading in a tight range around $55 per barrel and driving speculative bets on prices to record highs at the end of January. While the oil producers organization still faces an uphill battle in removing the global supply overhang that has weighed on oil markets since mid-2014, it might have just embarked on a brand-new supply management policy -- albeit one that it will have to make up as it goes along.

Crude production by OPEC's 13 member countries was down by around 800,000 to 1 million barrels per day in January compared with October 2016, the baseline used for the bloc's Nov. 30 output cut agreement, according to independent surveys. These surveys variously found a remarkably high 80-90% overall compliance by the 11 members bound by production ceilings as part of the deal to reduce supply by about 1.2 million barrels daily. Nigeria and Libya, which are exempted from the cut as their output has been constrained below normal levels by militancy and civil strife, respectively, both managed to increase production somewhat in January.  

OPEC kingpin Saudi Arabia, which played a key role in negotiating the agreements within the group and with major non-OPEC producers, went the extra mile by slashing its output to around 9.98 million barrels per day in January. That was below its allocation of 10.06 million barrels per day and 5.5% lower than the 10.56 million barrels per day it pumped out last October. Russia, which is shouldering 300,000 barrels per day of the nearly 600,000-barrel daily cuts agreed by 11 non-OPEC countries, pared down its output by 100,000 barrels per day in January as part of a phased reduction, a strong signal of its intent to follow through on its commitment.

The skeptics who have consistently doubted OPEC, starting with its ability to forge a meaningful output restraint agreement last November and extending to its ability to comply with it, may not be convinced yet. They likely expect compliance to dissipate or even collapse in the coming days. Non-OPEC collaboration, a crucial element in OPEC's decision to make a deep cut in its own output -- but something it has no direct control over -- could still trip the circuit. Proponents of free markets label OPEC a cartel, and argue that a rebalancing of oil supply and demand should be left to market forces.

It seems OPEC will silence the cynics this time around, not because they were mistaken in looking at the group's past production cut deals and drawing a logical conclusion, but because predictions often go wrong when they fail to account for a new variable in the equation. U.S. shale is that new variable this time around. It was the reason OPEC threw in the towel in November 2014 when it decided to abdicate as a swing oil producer, and it could now become the instrument for OPEC to reinvent itself.

More cooperation  

Yes, the world could have continued waiting for the market to naturally inch toward an equilibrium without OPEC intervention, but that would have been far beyond the point where the advantage of cheaper oil for the consumers outweighed the deterioration of economies in the oil-producing countries. If OPEC gets its new supply management strategy right, it would be neither "fixing" prices nor restricting competition -- two key elements that define a commercial cartel. Instead, it would be ending a destructive race to the bottom among its members and responding quickly and efficiently to changes in the world's oil supply and demand balance.

That new strategy will also need the cooperation of willing non-OPEC producers going forward. OPEC cannot do it alone. The combined crude output of OPEC and the 11 non-OPEC producers that have agreed to the cuts is around 50 million barrels per day, or nearly 62% of the global supply. This affords far greater leverage than the 39% share of OPEC alone. That leverage is essential to actively adjusting supply to match demand, as long as OPEC has to reckon with the 9 million barrels per day or more of crude production from the U.S., which is outside any artificial restraint and driven purely by economics.

This wider producer cooperation essentially dissolves the boundaries around OPEC, making it even less of a cartel. Its output restraint, if successful in putting a $50 floor under crude, will benefit all producers, including its "competition," the U.S. shale patch. OPEC officially gave up targeting a price band for crude in 2005, and it knows the era of "fixing" crude prices has long gone. 

The competition -- tight oil production in the U.S. -- has already received a shot in the arm from the more than 20% jump in crude prices since OPEC's November agreement. Rig count is not the only number that has been steadily rising in the U.S. since the second half of 2016 -- crude production has been climbing, too.

 U.S. output, nearly half of it tight oil from the country's shale plays, had grown to around 8.92 million barrels per day at the start of February, up almost 500,000 from a recent low of 8.45 million barrels per day in early October. The U.S. Energy Information Administration in its latest outlook projects a conservative year-on-year rise of 100,000 barrels per day in average production for 2017 in its latest outlook. Though that represents a sharp reversal from the 530,000-barrel drop in the daily average recorded in 2016, which snapped seven consecutive years of gains, growth in the coming months could surprise on the upside in both pace and magnitude.

This is where OPEC will need to script its new policy, by responding quickly and dynamically adjusting the output levels of its members and non-OPEC coordinators, whether by adding or subtracting supply, to keep the market balanced. Any rise in prices to a level that puts U.S. crude production back on a strong growth path will need to be counterbalanced.

Not only will the current six-month supply restraint agreement need to be extended beyond June, cuts will also have to be fine-tuned periodically, factoring in changes in world stock levels, oil demand growth and the quantum of increase in output from the U.S., as well as from Canada and Brazil, major non-OPEC producers not collaborating with the bloc. In oil's new world, there are no half-measures.

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

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