Post-OPEC Analysis: “Happy Days” or “Curb Your Enthusiasm”?
By most accounts, the Organization of Petroleum Exporting Countries (OPEC) successfully concluded its November 30 meeting by agreeing to extend the production cuts an additional nine months, to run through the end of 2018, and seeking to cap output from Nigeria and Libya, two members specifically excluded from the earlier pact. At the same time, the group announced that it will continue to monitor ongoing changes in global markets and would review the agreement at its next scheduled meeting in June. In the run-up to last week’s meeting, analysts had warned that OPEC’s failure to meet “market expectations” with the extension would likely cause oil prices to plummet. In fact, the meeting’s agreement produced no such upheaval, with Brent crude oil continuing to trade above $63 per barrel, although we would caution that persistently higher prices may eventually reintroduce periodic oversupply problems.
Several elements have combined to make OPEC’s strategy effective this year in working off the enormous global oversupply (in terms of inventory) and accelerate the rebalancing of global oil markets. The most notable of these include Saudi Arabia’s leadership and commitment to production and export caps, general compliance among other OPEC members, rising global demand, hurricanes in the U.S. Gulf of Mexico, and Russia’s continued participation in the agreement (see CSIS Commentary “ Russia and Saudi Arabia”). The November 2016 agreement established an aggressive new production target with a buy-in from Iran and Iraq and a promise from Russia to cooperate that has so far been kept (albeit with a lag in the early going). Technical experts in the OPEC Secretariat think that Iran, Iraq, Libya, and Nigeria are not likely to see significant production gains in 2018, and problems in Angola and Venezuela could provide the group some additional headroom. Complicating considerations for continuation of the OPEC/non-OPEC group on limiting production, however, is the internal division of economic interests within the countries between governments and companies.
Because of the way the taxation system works in Russia, the central government receives most of the financial benefit of oil prices above $40 per barrel (which incidentally is the price level on which the national budget is based), whereas Russian oil companies need to maintain or increase their production to justify investments they have made in infill drilling and developing new fields. In varying degrees, this is also true for certain countries within OPEC and the non-OPEC group (such as Kazakhstan and Azerbaijan) where foreign companies operate most of the production.
The contractual terms generally benefit the host government’s fiscal take disproportionally when oil prices rise, while the foreign companies operate on a margin basis that requires volume growth to increase profits and justify new investments. Such internal tensions are easy to overcome when oil prices drop below $30 per barrel, as was the case in January 2016, when both governments and companies were severely affected. However, maintaining production discipline within this temporary coalition of OPEC and non-OPEC countries is likely to be more challenging at a price of $60 or higher.
And although the OPEC meeting took place in Vienna, Austria, the Permian Basin and other U.S. shale regions clearly were on the minds of the delegates. For despite the obvious differences in crude quality and characteristics, the projected rise in U.S. output and exports is increasingly seen as a threat to OPEC members, who have voluntarily ceded market share in the interest of draining global stocks and attempting to rebalance the market. Such was the topic of the much overlooked technical-level workshop on tight oil that OPEC convened a week before the ministerial session, specifically aimed at examining the prospects for U.S. shale production.
Every business school teaches the importance of competitive analysis in designing a good business plan, and the shale workshop was part of OPEC’s strategy to stay informed. OPEC will need to monitor developments carefully in the Permian, Anadarko, and other basins and make sure that prices don’t encourage too much U.S. shale oil production or undermine demand growth going forward. Cost inflation, reinvestment rates, and productivity trends need to be closely watched and OPEC’s own production plans quickly adjusted accordingly.
Brent crude was still trading near $45 per barrel in May 2017 when OPEC’s deal was quickly renewed. Now, the slow reduction in global inventories accompanying the rebalancing of supply and demand has pushed Brent steadily upward to over $60 per barrel in November. And while estimates of U.S. output in the coming years vary widely, reports are that third quarter 2017 price levels have resulted in some 900 thousand barrels per day of production on an annualized basis already being hedged (providing producers with ongoing cash flow) and that drilled but uncompleted wells (DUCs) now exceed 8,000. At the other end of the spectrum, ongoing concerns over a myriad of issues could prevent output projections from being realized. Among these problems are frac hits/well interference, lack of takeaway infrastructure, water availability, personnel issues, overstressing formations, public concerns related to water contamination, use and disposal at scale, seismicity, and other matters.
And then there’s the issue of OPEC’s “exit strategy” and how they reintroduce volumes currently withheld from the market and whether geopolitical disputes or the draw of higher prices could undo the present level of cooperation and compliance. The Russians seem to be worried about prices rising too fast and encouraging too much shale, which could impinge on Russian expectations for their own capacity growth in 2019–2020. The Saudis undoubtedly worry about that too but are more likely focused on the goal of reducing the global inventory overhang across 2018, a period more applicable to the expected initial public offering of Saudi Aramco.
And just as reportedly there was no consensus at the workshop on the level of U.S. shale growth in 2018–2019, research analysts across the industry also remain divided on outcomes and timing. The November 30 OPEC meeting admittedly sustained higher prices and happy days for producers, but longer term, a cautionary note is warranted. Despite the extension of the official agreement to the end of 2018, if U.S. shale proves more robust than current expectations or demand disappoints, a midcourse adjustment could be announced next summer when the ministers convene in Vienna on June 22.
Adam Sieminski holds the James R. Schlesinger Chair for Energy and Geopolitics at the Center for Strategic and International Studies (CSIS) in Washington, D.C. Frank A. Verrastro is a senior vice president and trustee fellow at CSIS. Sarah Ladislaw is a senior fellow and director of the CSIS Energy and National Security Program. Edward Chow is a senior fellow with the CSIS Energy and National Security Program.
Commentary is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).© 2017 by the Center for Strategic and International Studies. All rights reserved.