Twenty-four oil-producing countries, members as well as non-members of the Organization of the Petroleum Exporting Countries, OPEC, met Thursday, 25 May, and voted to extend their production reduction accord by nine months, to April 1, 2018. The extension aims to rebalance the global oil market and stabilize oil prices. Investors however, viewed the effort as inadequate as oil prices fell about 5% in the wake of that meeting. Prices since ticked upwards somewhat, perhaps in anticipation of product drawdown during the driving season beginning with the Memorial Day holidays; but Goldman Sachs just lowered its 2017 price projections for both Brent and West Texas Intermediate oil grades.

The original production reduction accord ─ which saw a spike in both oil prices and energy company stocks in its wake ─ was signed in November 2016 and was a reversal of an earlier OPEC laissez faire production policy. While OPEC, as has been surmised, adopted that production policy in a bid to drive higher-cost (shale, oil sands, etc.) oil producers offline and garner greater market share, its implementation may have been mistimed. If the policy had been adopted before the massive investment in shale production, it would most likely have killed, or at least significantly deferred the rise of, shale oil; but shale oil, once birthed, has proved resilient.

The raison d’être for this accord extension may be that accruals from the marginal price increase would countervail losses from reduced production. But, with most of these producers dependent on oil proceeds for meeting budgetary provisions, its sustainability remains critical.

Oil Supply

While OPEC and its accord partners have been cutting oil production, United States shale producers have been ramping-up output. The accord provides for the excision of about 1.8 million barrels per day (MMbpd) of oil supply from the global market; but from its inception to the end of June, U.S. shale producers would have added 800,000 barrels per day (bpd) to that market, severely reducing the impact of the accord. U.S. shale oil output is expected to grow by 122,000 bpd in June to about 5.4 MMbpd, per data from the U.S. Energy Information Administration; that would represent an increase of almost 20% over the past seven months.  

Three factors have contributed to this ramp-up. First, loan forgiveness. Many of the heavily-indebted producers have been able to renegotiate their indebtedness and this has given them a new “lease on life”. Secondly, the initial uptick in crude oil prices following the production accord of November 2016 saw many of the producers rush to hedge their operations through 2017; and that has enabled them to keep producing despite price fluctuations. And finally, operational efficiencies gained from practices such as high-grading and enhanced drilling methods, which significantly reduced operating costs. The cost relief however, which enabled many of these shale producers remain operational during the oil price downturn, may be witnessing a reversal. For example, the current shortage of hydraulic fracturing crews ── a key element of shale oil production and many of which went out of business during the price downturn ── has raised production costs. Analysts estimate a cost inflation of up to 20% in 2017 and that may temper the shale output.

The most lucrative of U.S. shale oil producing acreages are currently in the Permian basin; however, if oil prices rise to about US$60 per barrel, production from acreages in other basins will become profitable and will add to the global oil supply, further tempering the impact of that accord.

OPEC members, Nigeria and Libya which were exempt from production cuts have seen their output rise significantly. Iraq, OPEC’s second-largest producer has also seen output rise, amid questions about her production data. Brazil, a non-OPEC member which is not participating in the production cut, is set to ramp-up output by about 45% over the next few years, beginning with an addition this year, of more than 200,000 bpd to the global market.

The effect of these supply additions is to further lighten the rebalancing weight of that production accord.   

Oil Demand

The current low-price regime for crude oil has not translated to a significant increase in demand for the commodity. OECD crude oil demand for 1Q17 fell from the 4Q16 level but remained unchanged from the year-ago level.

Most recent data (16 May 2017) by the International Energy Agency, IEA, indicate that demand growth estimate for 1H17 was curtailed by 115,000 bpd. The rather sluggish global economic rebound has not aided demand growth; 1Q17 growth in the United Kingdom for example, has been revised downwards to just 0.2%, though the International Monetary Fund, IMF, recently projected global economic growth to rise from 3.1% in 2016 to 3.5% in 2017. Some analysts have forecast a complete rebalancing of the oil market in the medium term if a global economic growth rate of 3-4% is maintained over that period. The current reality however is that verifiable oil stocks are still above the rolling 5-year average and rising. OECD oil stocks increased for 1Q17 and preliminary data for April also indicate an increase, per IEA.

The OPEC-led effort to rebalance the global crude oil market is buttressed on a reduction in supply and an increase in demand. However, both net supply reduction and demand growth have been below targets. The lack of clearly-defined strategies for addressing this has only added to market uncertainties; and could even lead to a reversion to that OPEC’s laissez faire production policy, which saw oil prices fall to twelve-year lows.  

All said, the accord has lifted oil prices from just under US$30 per barrel to about US$50 per barrel; but it remains uncertain, what happens in the likely event that the oil imbalance persists at the end of the current extension. This may have informed investors’ reaction to the accord extension, even as most have adopted a wait-and-see approach.