Where Do Oil Markets Go After The OPEC Deal?

Lately, oil markets have been finely balanced. Both the bulls and bears can make a compelling argument for their respective cases. Russia has vowed not to flood the oil markets while the compliance rates remain high. Inventories have fallen. Prices touched post 2014 highs at $71 a barrel (Brent) and $65 a barrel (WTI). Bears peddle the clichéd, yet not at all insignificant, story of U.S. Shale.

The IEA in its recent report said that U.S. oil production could reach 11 mbpd this year. Rigs are being added across the country, taking the total number of oil rigs to its highest level since April 2015. Much of the current situation is thanks to the Vienna deal that saved oil prices after they tanked below $26.

One might ask what will become of the markets after the deal expires. In other words, how long can the OPEC-NOPEC producers continue to cap output? With a rising U.S. production and the possibility that one day, and that day might come very soon, the oil producers will open their taps anew. On top of that, the lack of any drastic upbeat demand figures makes a bearish case for oil more than possible.

Credit can be given to the technological improvements and resilience of shale producers that kept pumping oil even when prices were low. But the Vienna accord, spearheaded and held together by Saudi Arabia and Russia, still managed to raise oil prices. Both OPEC and Russia have their interests in maintaining a healthy oil price. For every one dollar oil prices fall, Russia loses $2 billion in revenue. OPEC’s leader, Saudi Arabia, needs higher oil prices to ensure the successful IPO of Aramco. For these reasons, the deal was extended last year until the end of 2018. There are chances it might be extended further, but how much?

One can make an educated guess that the current production cuts can certainly hold until Aramco’s IPO, which is a huge bet on the country’s future. Once the IPO is done, we might expect weakness in the Saudi resolve to continue the deal. Russian executives are also losing confidence.

Last year in November, many energy industry executives expressed their concern regarding rising U.S. shale production. It remains to be seen for how long they can allow others to free ride on their efforts. The IEA reported that the U.S. will be a net exporter of oil and gas by 2022. Revising its estimates, it said that U.S. production will touch 11 mbpd this year (earlier estimates suggested this wouldn’t happen until 2019).

Other OPEC members are also gearing up to produce again. After signs of tightening oil markets, countries like Kuwait, UAE and Iraq have expressed their ambitions to increase production once the deal expires. Kuwait’s oil minister said that the country will raise its production from 3 mbpd to 3.225 mbpd by end of March. Iraq aims to edge up production to 5 mbpd from 4.6 mbpd by year’s end and Iran says it might add 100,000 bpd after the deal expires. We can be certain that Russians will increase production as well.

The members meet in June for a review meeting. Inventory levels are still above the five-year moving average, showing that they have work to do, but some members may be tempted for an early exit.

Dr. Mamdouh Salameh, International Oil economist and World Bank Consultant on oil & energy, is positive about oil prices. He says “Oil market fundamentals are positive enough to sustain an oil price ranging from $70-$75 in 2018. By this I mean that the global economy is projected to grow by 3.9 percent in 2018 and 2019 compared with 3.5 percent in 2017 according to the IMF. The global demand for oil is projected to add 1.7-2.0 million barrels a day (mbd) this year over 2017.”

Dr. Salameh was very upbeat when discussing the strength of the commitment between Russia and Saudi Arabia, saying that “OPEC and Russia have suffered a great ordeal with the steep decline of oil prices since 2014. That is why they never want to suffer that experience again.”

To rely on a single deal that limits production from certain members is not a good idea. Not to mention the fact that the production cuts continue to face challenges in the shape of rising U.S. production offsetting the effects. There is only one way to get out of this vicious circle of supply and price: Demand.

The IMF says that the world economy will witness growth this year. Eurozone economy is also picking up. Demand is also expected from India and China. Electrification of transport and policy changes supporting climate change are other factors to consider. The transportation sector is a major consumer of oil. China, with the biggest car fleet in the world, plans to ban conventional cars by 2022. France, India and other countries are following.

The recent talks about forming an OPEC Super group, a marriage between OPEC and Russia, has uplifted the sentiments again. However, it remains to be seen whether Russia will go along with this plan. Even if it does, the fact remains that such deals cannot be a permanent solution for stabilizing oil markets.

The threat from the U.S. is real and production cuts are not a long term solution to stabilize oil markets.

By Osama Rizvi for Oilprice.com