OPEC showing an unprecedented level of compliance

In the first two months of 2017 OPEC members have demonstrated an unprecedented level of compliance with the production cuts agreed in late 2016, according to The Economist Intelligence Unit (EIU). This marks a major reversal of the ‘free-for-all’ market-share strategy that Saudi Arabia and other Gulf Arab states had adopted in 2014 as they sought to combat the rise in US shale production, which had weakened OPEC's share of global output.

Data from the International Energy Agency (IEA) show that OPEC members met 90% of their pledged production cuts in January and February this year, with Saudi Arabia cutting its output even further than promised in order to compensate for weaker compliance elsewhere. For the duration of the six-month agreement, OPEC members plan to trim crude oil output by about 1.2mn b/d from October 2016 levels to 32.5mn b/d, extendable by another six months. The pain is designed to be shared equally – most OPEC members are to reduce output by around 4.6%. However, Nigeria and Libya are exempt, and Iran was granted a 90,000-b/d increase in its quota from October production levels. Boosting the deal's impact, a group of 11 non-OPEC producers agreed to join the effort, reducing output further by a combined 558,000 b/d. Around one-half of this total is meant to come from Russia.

The immediate, sentiment-driven boost to prices stemming from OPEC’s commitment has largely been sustained. In December 2016, following the announcement of the deal, the price of dated Brent blend jumped above $55/b for the first time since mid-2015. Since then, however, prices have largely remained within a tight band of $55–$57/b, as the impact of OPEC’s restraint was partially offset by other factors, particularly from the US market.

The EIU expects US crude oil production to rise by 2.8% year-on-year in 2017 (from 1.5% growth previously), the sustained rise in prices in late 2016 and early 2017 encouraging US shale drillers and pointing to a revival. (The US oil-rig count, compiled by Baker Hughes, jumped from a low of 316 active rigs in May 2016 to 756 by 3 March 2017). The prospect of higher US shale oil output, coupled with above-average crude stockpiles in the US – which have been building rapidly in late February/early March, despite only modest consumption – will limit faster price growth in 2017.

The EIU nonetheless remains of the view that annual average oil prices will be higher in 2017 than in 2016, driven by a modest rebalancing of the oil market. Greater OPEC restraint will be the primary factor in this rebalancing. The prospect of a sharper than expected rise in US shale production in late 2017 is a key downside risk to the forecast, as higher market supply would erase recent price gains. OPEC producers, led by Saudi Arabia, opened talks with major US shale producers in early March, in an attempt to reach consensus on the need to moderate production growth.

For now, it believes that OPEC is likely to extend its production cut agreement by another six months in order to complete the market rebalancing and sustain price growth. However, if US producers are perceived to be taking advantage of higher prices created by OPEC restriant, the deal could fall apart later in 2017.

The EIU also remains skeptical that other non-OPEC producers will fully respect their commitment to lower their production quotas. Russia’s offer was ‘vague and came with caveats’, it reports. In contrast to its counterparts in many OPEC countries, the Russian government has no established mechanism for restricting oil output, and senior figures in the industry are known to be opposed to cutting production. Russia pumped almost 11.5m b/d in January 2017, 100,000 b/d fewer than in December 2016, but it remains unclear whether this was because of compliance with the OPEC deal or a consequence of the cold winter weather making operating at capacity impossible. Considering production more broadly, a number of new oil fields are due to come onstream in 2017, which, all else being equal, will push production higher, notes the EIU.

The lack of policy clarity under the new US president, Donald Trump, is also seen to be a key risk to the EIU price forecast. Energy policies in the US that favour domestic oil producers may, by boosting supply, exacerbate downward pressure on prices. However, if Trump chooses to take the US out of the 2015 Paris Agreement on climate change (or merely disregarded its targets), stronger demand for fossil fuels would be supportive of oil demand, and therefore prices. A relaxation of sanctions against Russia would be a gift to its oil producers, but the impact on global supply could be offset by a reintroduction of sanctions on Iran. 

The price rally will lose steam in 2018 as some countries ease their production limits in order to take advantage of higher global prices, leading to an unravelling of the OPEC deal. In addition, the EIU expects Chinese consumption to soften in line with an abrupt slowdown in industrial production and investment growth there, which will have negative knock-on effects on other economies and weigh on sentiment globally. As a result, it expects Brent prices to rise only modestly, to an average of $60/b in 2018. These will fail to rise much higher in 2019–2020 amid continued output growth from OPEC countries and, in 2019, a recession in the US. Prices will begin to edge up only in 2021, rising to $64/b, it predicts. Steady demand growth and slower increases in OPEC production will provide support, and the effect of several years of low investment will be felt more markedly in higher-cost producers.