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Economy

OPEC wins this round, but now a war looms

Group inks historic production-cut deal, but internal discord, price pressure remain

In a nail-biting finish, OPEC delivered on its Algiers promise by sealing an agreement in Vienna on Nov. 30 to pare back its crude production to 32.5 million barrels per day, effective Jan. 1. The move propped up the price of Brent crude to 15-month highs in a spectacular rally over the two days that followed, as this column went to press.

The size of the promised cut, though pegged at 1.2 million bpd by the ministers and seized as the headline figure by the world media, is more likely somewhere between 960,000 bpd and 1.14 million bpd, depending on the starting point, or the "baseline," in OPEC's parlance. One of the most remarkable policy U-turns and hard-fought victories over internal discord in OPEC's history, the agreement carries with it the seeds of confusion and doubt.

First, the obvious pluses. By veering toward the lower end of the 32.5-33.0 million bpd target range proposed under the Sept. 28 resolution in Algeria, OPEC not only silenced its critics with a hastily cobbled-together consensus and a "meaningful" cut, but also seized the moral authority to seek a commensurate reduction from Russia and some of the other major producers outside the group. It said its cut was contingent on the non-OPEC producers doing their part, but that could be seen as posturing.

Though the new-look OPEC, under the leadership of Nigerian Secretary-General Mohammed Barkindo, has been lauded for being more transparent and communicative, its deal cloaked the vital detail of the new ceiling agreed for each member country. This left the market to do the math from scraps of information shared by the ministers and officials on the sidelines of the Vienna meeting, and extrapolations offered by reporters and analysts.

The latest country-wise production figures, needed to calculate the size of the cut, were contested by several members leading up to the agreement, and a few exceptions appear to have been made at the last minute to using October data from "secondary sources" as monitored by OPEC. But in the absence of official word on the matter, conjecture and discrepancies lingered.

Nigeria and Libya, suffering major disruptions to their production from militant strife and a civil war respectively, were exempted from the deal, while Indonesia opted out by suspending its OPEC membership, saying it was unable to accede to cutting its output by 5% -- details omitted from the official communique.

Iran agreed to cap its output at 3.797 million bpd -- interpreted by some as room for a 90,000 bpd increase from the country's latest estimate of its production at 3.707 million bpd, but a drop if measured against its earlier claims of having reached 3.9 million bpd. The Islamic republic wanted to be allowed to regain its pre-sanctions level of 4 million bpd.

The other major producer to stand down was Iraq, which had variously demanded an exemption, and a nearly 200,000 bpd higher baseline than the one OPEC wanted to use. In the end, it agreed to a prorated reduction, and from OPEC's secondary sources baseline.

All in, it was a diplomatic coup for OPEC kingpin Saudi Arabia, whose desire for an equitable distribution of the cut prevailed over Iran and Iraq's arguments for special treatment, which had threatened to scuttle the deal at the eleventh hour. The question now is, will Iraq and Iran, OPEC's second and third largest producers behind Saudi Arabia and the two biggest contributors to the surge in the organization's output since 2014, toe the line or, stung by their defeat, lose the will to comply.

The 600,000 bpd cut OPEC hopes to secure from its collaborators -- principally Russia, Azerbaijan, Kazakhstan, Oman, Mexico and Brazil -- had started to come together, at least on paper. Russian Energy Minister Alexander Novak pledged support and said he was optimistic about OPEC's "historically important" agreement, but did not spell out whether his country would climb down by the proposed 300,000 bpd from its post-Soviet record-high output above 11 million bpd. Skeptics point out that Russia's difficult geology, old reservoirs and harsh winter weather conditions make regulating crude production especially challenging.

Mexico's Secretariat of Energy on Dec. 1 said the country would reduce its output by 215,000 bpd effective Jan. 1 to 1.944 million bpd. Though appearing to be in solidarity with OPEC, the Mexican government had flagged this decline in 2017 back in September, in line with the longer-term trend in the country.

The six non-OPEC producers collectively account for just under 20 million bpd of production, but could leave Russia and Mexico to do much of the heavy lifting, helped by Oman, which has promised a 5-10% cut from its output of just over 1 million bpd. Brazil, Azerbaijan and Kazakhstan's contribution remains unclear.

If all goes according to plan, the collective action promises to remove 1.8 million bpd of supply (by OPEC's calculations) from the market over the first half of 2017. That was exactly OPEC's latest estimated overproduction compared with the projected demand for its oil in the first half of 2017, without a cut. It's early days, and the bulls have given a thumbs-up to OPEC's math. But their report card on compliance will determine the fate of the rally after January.

Saudi Oil Minister Khalid al-Falih, who takes the helm as OPEC president in 2017, will have to lead by example. The kingdom will need to deliver on its own hefty cut of about 474,000 bpd, and ensure overall quota discipline. If OPEC's own cut loses credibility, the non-OPEC producers can hardly be expected to hold up their end of the bargain.

Critically, the U.S., whose surging production has contributed to much of the world's supply glut since 2014, as well as neighboring Canada, will not be part of the mop-up exercise. U.S. crude production, roughly half of which comes from its shale plays, averaged about 8.9 million bpd in the first nine months of this year, just 500,000 bpd lower than the 2015 average. The U.S. Energy Information Adminstration in its November short-term energy outlook forecast that annual production will shrink by a mere 100,000 bpd in 2017, a view that could well change as the post-OPEC agreement price rally gives shale producers a shot in the arm.

OPEC may have wrested back its credibility crown, but the jury is still out on its relevance. Paradoxically, if it is too successful in removing the supply it has pledged to remove, it might give a leg-up to its nemesis, the shale patch, and perhaps even the oil sands in Canada. Striking that balance might be the most formidable war ever for OPEC.

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

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