The battle between OPEC and shale oil producers can be characterized as a two-round fight. In the first round, shale producers gained market share and the price of crude crashed. In the second, OPEC curbed output as shale producers adapted to the lower prices. Now, get ready for round three, as OPEC and Russia try to plot a way out of their production cuts but likely get stymied by market twists and turns that upset their calculations.
The approach of OPEC and its allies for the coming year is clear. Brent crude has just risen above $70 per barrel, apparently confirming the success of OPEC’s plan. Production cuts have been extended until the end of 2018, and excess inventories are being drawn down. But as usual, demand in the first half of the year looks to be relatively weak, meaning any reduction in inventories will have to come in the second half.
The reality, especially if prices exceed the $70 mark, is that the fundamental supply-demand balance does not support OPEC’s optimism. Even if it did, transitioning away from supply cuts is not going to be smooth, with growth in demand likely to weaken throughout 2018. Some Russian companies seem to be itching to part ways with OPEC even though Russian Energy Minister Alexander Novak said he doesn’t see “balance” being achieved until the third or fourth quarters of next year, adding that the deal to curb supplies could be extended again, to beyond the end of 2018.
A sudden abandonment of production limits and an increase of some 1.5 million barrels per day, previously cut, might not cause a sharp price slump this year, but would definitely do so in 2019. Saudi Arabia’s expansionary new budget factors in a Brent crude price of around $60 per barrel, but even that would leave the deficit at a hefty 7.6 percent of gross domestic product, according to estimates by investment bank Jadwa. The budget would only balance at $81 per barrel.
In any case, a smooth withdrawal from production curbs would be tricky. Some adherents — Saudi Arabia and Russia — have the ability to boost output significantly from current fields. Riyadh itself plans to reach 11 million barrels per day by 2023, up from less than 10 million now. Others, such as Iraq and the United Arab Emirates, are working on expansions, and Iran will eventually, too, if it isn’t derailed again by political turmoil or sanctions. Others are in slow decline, such as Qatar and Algeria, or a more rapid plummet, in the case of Venezuela. It will take discipline for members to slowly boost output to some intermediate target. More likely, there will be a rush for the exits.
But should the bloc begin working on an exit strategy at all, when victory is still undeclared? Opinions vary widely on what constitutes balance. OPEC sees supply growth of 1 million barrels per day this year, of which 720,000 would be from the U.S. The International Energy Agency is calling for 1.6 million, with the U.S. contributing 870,000. But if prices remain elevated, the IEA’s forecast looks conservative. Consultancy Rystad Energy estimates as much as 1.9 million barrels per day of growth, with 1.6 million coming from the U.S. Higher oil prices today are allowing shale producers to hedge and lock in drilling programs. Costs will inevitably rise as activity gears up, and there is much talk of a new capital discipline, but prices above $60 per barrel offer a win-win of profits and growth.
OPEC believes demand will grow by 1.53 million barrels per day, down just slightly down from 2017’s strong 1.7 million, while the IEA has it at 1.3 million. Offsetting the contrasting views on supply and demand leads to a difference between the two agencies of 800,000 barrels per day. Last year’s 15 percent rise in prices, following the 74 percent gain in 2016, would normally be expected to curb demand significantly. A slowing Chinese economy is a further threat. Yet the IEA sees inventories hardly diminishing in 2018, while OPEC believes they would be back at the five-year average by year-end, though this figure is inflated by the recent history of excess stocks.
A more plausible narrative than OPEC’s forecast of a measured return to “balance” is as follows: Weaker demand in the first half of 2018 meets a surge in U.S. shale production as the effects of higher prices and hedging feed through. But this is concealed by Venezuela’s slow-motion collapse as its exports slump, and by periodic upsets in Libya, Nigeria and other wildcards similar to the recent Forties Pipeline breakdown in the North Sea.
By the second half of the year, demand is less robust than hoped, and Russia, the U.A.E. and Iraq — via a deal on Kirkuk exports with the Kurdish region — are champing at the bit to release their production. Despite the heralded “bromance” between Saudi Energy Minister Khalid Al-Falih and Russia’s Novak, Russia feels the OPEC deal has achieved its aims. Saudi Arabia faces a dilemma on whether to hold the line on production cuts and lose market share, or reimpose discipline. The deal falls apart and prices slump again.
This prospect makes it clear that OPEC and its allies don’t need an exit strategy, but rather a long-term framework to manage restrained production growth. They cannot afford another price slump. Neither should they risk another price spike, a surge in shale production, damage to demand and enhanced interest in electric vehicles. If the coalition shatters in 2018’s combat with shale, it will be very hard to put it back together.
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Frontpage November 4, 2019