OPEC is on the verge of extending its production cuts for an additional nine months, pushing the deal through the end of 2018. But the determination to keep the cuts in place comes at the same time that U.S. shale seems to be accelerating in response to higher oil prices.
It’s an impossible tension that OPEC has to deal with. Hesitate on cuts and risk another slide in oil prices, or keep the cuts in place and offer more room to U.S. shale?
OPEC has tried to send a signal to the oil market that the group is operating with a consensus, and it telegraphed its intentions ahead of time to inspire confidence in the group’s cohesion. By demonstrating such resolve, the logic seems to be, the oil market would continue to tighten and prices would remain stable.
But the downside of such a strategy is that it isn’t just oil traders who are confident in a more balanced oil market – U.S. shale has kicked drilling into a higher gear recently, and appears poised to continue to ratchet up production. The rig count has climbed for several consecutive weeks, and U.S. oil production is on the brink of hitting an all-time record high.
The difficulty for OPEC, as Bloomberg Gadfly notes, is that the estimates for how much supply the U.S. will add next year differ by a wide margin. The IEA predicts non-OPEC supply growth by about 1.4 million barrels per day (mb/d) in 2018, a massive sum that would overwhelm demand. In this view, the OPEC cuts are badly needed to avoid another price collapse. OPEC is more hopeful that the shale industry will struggle; the cartel only predicts non-OPEC supply growth of less than 900,000 bpd next year.
There are plenty of signs to suggest that the shale industry is indeed facing unexpected troubles. But the problem for OPEC is that it simply can’t forecast with any accuracy what to expect from shale drillers over the next year.
Nevertheless, the objective of the OPEC production limits is to drain global crude inventories back down to average levels, a goal that will take more time to reach. With that in mind, it would make sense that the group locks in an extension of the agreement in a few days’ time.
But while there are some warning OPEC about a shale comeback, there are also voices that are warning OPEC that it could be doing too much. Brent is already safely in $60-per-barrel territory, and extending the cuts through next year could push prices up even more. “I’m used to OPEC not doing enough,” Rainer Seele, CEO of OMV AG, said in an interview with the Wall Street Journal. “Now they are over-delivering.”
Higher prices might be the result. “There’s actually a chance the market will over-tighten and prices go close to $70 soon,” Doug King, chief investment officer of the Merchant Commodity hedge fund, told the WSJ. At those prices, analysts worry about demand destruction.
The tricky thing for OPEC is that there isn’t much of a middle ground. OPEC is “also vulnerable if they don’t extend, that will spook the market,” Doug King said to the WSJ. There are risks for both keeping the cuts in place and letting them expire.
But because of the threat of an immediate price collapse, it is difficult to see how OPEC exits from its production limits. “Now that they’re in it, I don’t see how they get out of it,” Mike Wittner, head of oil market research at Societe Generale, told Bloomberg. “They need to continue supply management for the foreseeable future.”
An exit from the production limits will probably only become palatable when the oil market is much tighter – inventories at average levels, either a supply/demand balance or a slight deficit, and higher prices. In that context, especially with Saudi Arabia queuing up an IPO of Saudi Aramco, OPEC will likely err on the side of overtightening and allowing U.S. shale to come back more forcefully. The only question, at this point, is if Russia is on board.
By Nick Cunningham of Oilprice.com
