Here’s a three-word graduate course in economics: supply and demand.
When OPEC announced a six-month agreement to curb production and reduce the world’s crude-supply surplus, responses came from two main camps.
The first group included those who believed the move would materially affect the global supply of crude oil.
“This deal is significant. It sends a very strong message to the market and it should help the market find a balance,” said Simon Flowers, chief analyst for Wood Mackenzie in Edinburgh.
“It remains to be seen how well they stick to the plan, but if OPEC hadn’t come to an agreement the probability is that oil prices would have fallen to $40 per barrel, perhaps even lower,” he added.
Flowers has a cautiously optimistic outlook for the price of crude oil this year.
“We expect it to trade at an average of $55-60 in 2017, which shows that the agreement is very significant indeed. However, this does depend on OPEC being very careful to meet the terms of the agreement,” he said.
OPEC members agreed to reduce oil production by almost 1.2 million barrels a day. Saudi Arabia said it would limit its daily oil production to just over 10 million barrels – a cut of around 486,000 barrels a day from recent levels.
Iraq, now the second-largest producer in OPEC, agreed to cut 210,000 barrels a day from October 2016 levels. The United Arab Emirates consented to reduce crude output by 139,000 barrels a day and Kuwait by 131,000 barrels a day.
In a concession to Iran, where production had been constrained by international sanctions for a decade, the country would be allowed to increase oil production slightly to about 3.8 million barrels a day.
Additionally, 11 non-OPEC countries later agreed to reduce output by 558,000 barrels a day. Russia pledged the largest reduction, saying it would try to cut production by as much as 300,000 barrels a day.
OPEC members Libya and Nigeria weren’t included in the reduction plans; Indonesia was recalcitrant and its OPEC membership was suspended. All together, 10 OPEC oil ministers promised that their countries would reduce crude output.
Easier Said Than Done
Skeptics quickly observed that a lot of people would have to keep their promises in order to make a meaningful dent in the world’s oil supply. And producers in the United States are free to go right back to drilling.
That camp of opinion doubted if OPEC could swing production low enough to stabilize and then increase crude oil prices over the long haul.
“Whilst this is the first agreement to cut output in eight years, the deal will be hard to police. It is also based on the expectation that major non-OPEC countries such as Russia will voluntarily reduce their output,” said Jayesh Parmar, partner in the Baringa Partners consultancy in London.
Parmar said oil prices could rise sharply in the short-term, “but I don’t expect the price momentum to be sustained.”
The critics also noted that an understanding-in-principle to cut production was a long way from a full commitment by participating OPEC members.
“The first thing that has to happen is that they have to get an agreement,” said Michelle Foss, chief energy analyst for the Bureau of Economic Geology at the University of Texas (UT) at Austin.
Foss said the world is “just sloshing in product,” a situation exacerbated by the amount of crude oil now coming from nontraditional sources.
“We’ve got a lot of barrels coming into the market in the first half of 2017,” she said. “I’ve suggested at UT that we can expect oil in the $40s all year.”
North American production is another important piece of the world crude-supply equation and independent producers “have no choice but to monetize the acreage they’re leasing. That’s the situation in the United States and it’s not easy to fix,” Foss said.
Global oil supply is a hard thing to control, she noted. She’s skeptical that OPEC can stick to an equitable agreement without members cheating, and she’s skeptical that the rest of the world will also consent to hold down crude production.
“The third bit of skepticism is that all the new barrels that are scheduled to come into the market are actually going to come in, and that’s going to undermine the agreement,” Foss said.
Optimistic Realists
As last year ended, a third group began to emerge in response to the supply reduction agreements.
That camp assumed cheating on quotas would take place and reduction targets wouldn’t be met – but also, that there would be enough cuts to start whittling down the world’s crude surplus, leading to higher oil prices.
“At this juncture, the OPEC output cut could swiftly tighten the supply and demand balance in the first half of 2017. The agreement may not be fully adhered to, but even at partial implementation, there would likely be steady implied stock draws during 2017,” said Ann-Louise Hittle, principal analyst for Wood Mackenzie.
“In terms of implementation, (the OPEC agreement) is unlikely to be fully implemented. Even if it’s only implemented halfway, it’s going to materially affect production,” said Jim Burkhard, chief of oil market research for IHS Markit Ltd.
What the agreement does is put a more stable floor underneath world oil prices, Burkhard noted.
“It diminishes the size of the downsize risk. Without that deal, it looked like we were headed into another year of surplus production over demand,” he said.
Burkhard agrees that U.S. production capacity continues to be “the elephant in the room right now.” He said the industry’s cost structure has deflated remarkably over the past two years, lowering breakeven points for domestic producers.
“It comes down to something simple: the oil price and the amount of financing available,” he said. “How much money is flowing to West Texas and Oklahoma? We know there are lots of prospects that can be drilled.”
Based on recent experience, independents can be expected to boost drilling and output when U.S. crude prices exceed $50. Neal Anderson, Wood Mackenzie president, said “it’s challenging (for them) until oil approaches $50, and then they cautiously go back.”
In regard to the question of whether or not the production-reduction agreements will lift oil prices during the remainder of 2017, the consensus opinion appears to be “yes,” “no” and “maybe.”
How will OPEC’s actions affect oil prices and industry activity over the next 12 months? We’ll know for sure in about a year.
In the meantime, keep an eye on crude oil supply and demand.