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OPEC's 'whatever-it-takes' pledge may exact a high price

Imperative for group to continue recalibrating under extension of cuts

| Middle East
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Saudi Arabia's Energy Minister Khalid al-Falih, left, and Russia's Energy Minister Alexander Novak attend a joint briefing in Beijing on May 15.   © Reuters

The energy ministers of Saudi Arabia and Russia, the world's two biggest crude producers and de facto leaders of the 22 countries restraining output in a bid to end a three-year-old global oil glut, played their trump card on May 15. Together, they declared they would "do whatever it takes" to achieve the goal of stabilizing the market and bringing global oil inventories back to five-year average levels.

The last time the "whatever it takes" expression was famously evoked was by European Central Bank President Mario Draghi, whose impromptu use of it at an investment conference in London in July 2012 sent a powerful signal to the financial markets of his determination to tackle the spiraling sovereign debt yields that were crippling the eurozone at the time.

The phrase, used in a joint statement by Saudi Energy Minister Khalid al-Falih and his Russian counterpart Alexander Novak issued after their meeting on the sidelines of China's Belt and Road forum in Beijing, though, was no ad-libbing. It was deliberate and calculated to reassure the increasingly jittery oil markets that despite crude crashing to five-month lows in early May, OPEC and its non-OPEC collaborators were still in charge.

The two ministers said they had decided to recommend to their OPEC and non-OPEC peers that the 1.8 million barrels per day of combined production cuts in force since January this year be rolled over to March 2018. The agreement between the two suggests that a nine-month extension of the cuts is as good as a done deal when OPEC meets in Vienna on May 25.

Shale card

Benchmark Brent and West Texas Intermediate crude futures rallied by a dollar or nearly 2% on the day of the news, but were unable to sustain an upward momentum. In the following days, they continued to languish around 9% below the 17-month highs touched in early January, when hope for the cuts swiftly rebalancing the market was at its peak.

That hope, despite OPEC's consistently strong adherence to its pledged output reduction and the non-OPEC bloc's steadily improving discipline since January, has been tamped down by anxiety over the slower-than-anticipated fall in bloated oil inventories in the Organization for Economic Cooperation and Development countries and fear that U.S. oil production is on a trajectory to nullify the coordinated restraint of the OPEC/non-OPEC producers.

That bearish sentiment grew this month, with all three major organizations closely tracked for their oil market data and assessments -- the Paris-based International Energy Agency, OPEC and the U.S. Energy Information Administration -- jacking up their projections for non-OPEC oil supply growth this year, led by the U.S.

The IEA's May report cited strong growth in the shale sector as the reason to revise up its expectations of U.S. crude output. It expects the U.S. to exit 2017 with crude production 790,000 bpd higher on average than at the end of 2016, which points to a level of about 9.57 million bpd.

OPEC's May report revised the expected on-year rise in non-OPEC oil supply in 2017 to 950,000 bpd from 580,000 bpd a month ago. The U.S. alone would account for 820,000 bpd of that growth, according to OPEC's estimates, of which growth in tight oil is expected to contribute 614,000 bpd. The remainder includes condensates and other liquid fuels.

The EIA this month also raised its forecast for U.S. crude production, projecting a jump of around 430,000 bpd to a 2017 average of 9.308 million bpd. Next year is expected to see an even bigger leap of 650,000 bpd to a new historic high of 9.96 million bpd, it said. The agency has been somewhat conservative in its estimates, steadily revising up the figures from January's 9.0 million bpd and 9.3 million bpd for 2017 and 2018, and we could see further upward revisions in the coming months.

Whither OPEC?

Where does that leave OPEC with its new market-management policy? Still some distance from its goal of removing the surplus in oil inventories, at least the ones that are observable and measurable.

Data on the non-OECD world and barrels in floating storage is nowhere near as reliable or current as in the OECD countries. The IEA believes OECD stocks grew by 300,000 bpd in the first quarter, but with barrels having flowed out of floating storage, the net global impact was a build of just 100,000 bpd.

That build, however, when viewed in conjunction with expectations of a shale resurgence, is enough to make the market unsure about the timeline for a supply-demand rebalancing. Hedge funds and other major speculators that were aggressively betting on a strong crude price rally right until Feb. 21, the point at which they held historic high net long positions in ICE Brent and Nymex WTI crude futures, had unwound more than 40% of that length as of May 9 and are regarded to have retreated to the sidelines for the time being.

What might bring them back and lift crude to the mid-$50 range or even higher? As no one is counting on U.S. crude production growth being arrested in its tracks or a "demand shock" mopping up the world's surplus, a sizable, measurable and sustained draw in global oil stocks is the obvious answer. When might that happen? According to the IEA, it has already started: in April. The second quarter should see inventories dropping by 700,000 bpd on average, according to the agency's calculations.

However, there are a few risks to that scenario, which OPEC needs to factor in if it is to walk the talk on doing "whatever it takes." The biggest among them is rising production from Libya and Nigeria, OPEC members exempted from the output restraint agreement. If the cuts are extended under the current arrangement, as suggested by Saudi Arabia's al-Falih at a press briefing in Beijing, Libya and Nigeria could effectively sabotage the efforts of the remaining 11 OPEC peers, in addition to endangering cohesion and compliance within the OPEC and non-OPEC blocs.

While granting an exception was understandable in November 2016 in view of the fact that both Libya and Nigeria were pumping way below their capacity, knowing what we know of the oil market conditions today, the gesture may not be viable under an extension.

A bigger, quicker surge in U.S. production than hitherto seen also threatens to frustrate the OPEC/non-OPEC strategy to achieve market equilibrium. Accounting for that means OPEC would need to revisit and whittle down, if necessary, the participating countries' quotas through the duration of the extension.

In the long run, though, "whatever it takes" might exact too big a price to pay for the OPEC and non-OPEC producers: Requiring them to leave the 1.8 million bpd in the ground for the foreseeable future.

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

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