OPEC is reaping the rewards of stronger oil markets following its historic agreement with key non-OPEC producers to rein in crude production aimed at rebalancing oversupplied markets and supporting oil prices in a higher trading range in 2017. Prices for benchmark crudes have risen by around 20 percent on expectations key oil producing countries will deliver on pledges to reduce supplies. Agreements to cut production were reached by OPEC on November 30, 2016 and by non-OPEC producers on December 10, 2016. So far this year, U.S. West Texas Intermediate has been trading in a higher range of $52-53 per barrel (bbl) and international Brent crude at around $55-56/bbl. The current higher levels compare with the 2016 average price for WTI of $43/bbl and Brent at $44/bbl.

Indeed, latest reports suggest OPEC and its non-OPEC partners are already making solid progress on promises to curtail production. At a January 22 meeting of the committee set up to monitor compliance with the accords, officials reported that production has been reduced by 1.5 million barrels per day (mb/d), or 80 percent of the agreed total reduction of just over 1.7 mb/d pledged by the 24 counties participating in the agreements. OPEC’s Gulf Arab producers account for two-thirds of the decline, with Saudi Arabia reporting that the kingdom is producing below 10 mb/d, even lower than its new quota.

Oil traders have propelled prices higher over the past eight weeks anticipating production cuts. The initial exuberance that prices were on a solid upward trajectory following the agreements, however, is now being checked by market fears of a stronger than forecast rebound in shale oil production. Latest data shows a rapid increase in the number of drilling rigs in operation in U.S. shale oil fields, raising alarms that output will start offsetting lower OPEC production in the next few months. OPEC and non-OPEC officials downplayed the concerns at their monitoring meeting, arguing any increase shale oil output would be absorbed by rising demand. Indeed, while current industry forecasts project shale oil output will steadily rise throughout the year, global oil demand growth will more than outpace the increases. The International Energy Agency’s latest market forecast estimates U.S. shale output will increase by 170,000 barrels per day (kb/d) on an annual basis while global oil demand is projected to grow by 1.3 million barrels per day (mb/d) in 2017. The OPEC Secretariat and the U.S. Energy Information Administration are forecasting similar trends in their most recent monthly oil market reports, though the latter is expecting much stronger global oil demand growth of 1.65 mb/d.

Nonetheless, the rapid surge in production of fast-cycle shale oil has consistently exceeded expectations over the past decade, upending industry forecasts time and again, and has set in motion the massive build in global oil stocks since mid-2014, which led to the corresponding decline in oil prices. The ability of shale oil producers to surprise has not been lost on industry analysts, who initially failed to foresee the transformative impact of this new unconventional resource on global supply dynamics and prices. OPEC is also all too aware of the many uncertainties surrounding shale oil after miscalculating the ability of the fast-cycle supply to adapt to a lower price environment in its battle for market share.

OPEC’s November 2016 decision to reduce production is a calculated risk that the cuts in supply will significantly hasten a drawdown in the massive surplus of global inventories that have weighed on markets for the past several years and, combined with robust oil demand, propel prices to a higher $52-58/bbl range. Driven by the catastrophic plunge in oil revenue since mid-2014, OPEC is betting that a rise in prices will more than offset lower production levels. OPEC’s challenge now is to maintain prices in a higher but narrow price band in a bid to deliver a substantial improvement in government oil revenue but at the same time making sure they are not so high as to encourage a surge in U.S. shale oil production, which in turn would pressure prices lower again. For OPEC’s cash-strapped governments, a rough calculation based on the new lower production target of 32 mb/d and a $12/bbl price increase above annual 2016 levels to a sustained $55/bbl would translate into more than $100 billion in additional oil revenue in 2017. For Saudi Arabia, which has committed to providing a significant 42 percent of OPEC’s pledged 1.2 mb/d cut in supplies, a $12/bbl rise in prices equates to an increase of around $3 billion a month, or $36 billion for the year, which more than offsets its lower output. Underscoring Saudi Arabia’s confidence in OPEC’s new production accord, the government appears to be using an oil price assumption of $55/bbl for projecting oil revenue in its 2017 annual budget.

Global Oil Data Supports Market Recovery

Supply-and-demand data in the IEA’s January 19 Oil Market Report project the much-delayed rebalancing of global oil markets will take hold during the first quarter and accelerate through the remainder of the year. The return to a more balanced outlook is due to a combination of reduced production from OPEC and its key non-OPEC partners, sharply lower capital investments in non-OPEC projects over the past few years, and continued robust global oil demand.

Oil supplies have outstripped demand over the past three years, and cumulatively pushed global inventories to record levels above 3 billion barrels. The IEA’s monthly report now forecasts demand will outstrip supplies by an average 700 kb/d in the first two quarters of 2017, which would lead to the first significant drawdown in inventories since 2013. If OPEC and non-OPEC countries extend their agreements for the full year, demand could exceed supplies by an even steeper 1.15 mb/d in the second half of the year.

According to the IEA, its projection of a 1.3 mb/d increase in global oil demand, rising to 97.8 mb/d in 2017, is slightly lower than the upwardly revised 1.5 mb/d growth posted in 2016, but in line with the five-year trend from 2011-15. Global oil demand growth for 2016 was revised higher following a jump of 1.6 mb/d in the fourth quarter due to a combination of resurgent industrial activity and colder winter weather conditions, largely in Europe and Japan. Non-OECD economies are expected to provide all of the growth in 2017, with non-OECD Asia accounting for around 70 percent of the increase. Led by China and India, non-OECD Asian demand is forecast to rise by just over 900 kb/d to 25.9 mb/d.

Non-OPEC Production Rebound Forecast 

Some industry analysts believe the path to higher prices will soon face headwinds from the strong recovery forecast for non-OPEC supplies this year, especially the U.S. shale oil patch. Even after allowing for pledges to reduce output by Russia and 10 other non-OPEC countries, the IEA nearly doubled its forecast for non-OPEC supply growth for 2017, in part to reflect a sharp upturn in planned capital expenditures in the United States. Non-OPEC production is projected to rise by around 400 kb/d to an average 58 mb/d in 2017, after posting a steep year-on-year decline of 900 kb/d in 2016. However, the much higher volumes are not expected to hit the market until the second half of the year, with the IEA forecasting non-OPEC supplies unchanged from 2016 levels at 57.5 mb/d in the first six months of the year before rising by 700 kb/d to 58.4 mb/d from July to December.

The improved outlook for non-OPEC production also reflects recent upward revisions to planned capital spending in 2017 in line with higher prices following the OPEC-led production agreements and subsequent rise in oil prices. New projections showing a significant increase in exploration, development, and production spending this year have led industry analysts to revise upward their forecasts for non-OPEC supplies. Barclays’ Global 2017 E&P Spending Outlook, a much-watched survey of oil producers, forecasts global upstream spending will increase by an estimated 7 percent after two years of double-digit declines of around 25 percent. “With OPEC putting a floor on oil prices, operators have greater confidence to drill and complete, although the early stages of the recovery will be uneven,” Barclays’ analysts noted in the report. Global upstream capital investments are forecast to rise to $405 billion in 2017 compared with $377 billion in 2016. Overall capital expenditures in North America are forecast at $98 billion, a sharp increase of 27 percent versus a decline of 38 percent in 2016, and, crucially for forecasters, U.S. oil and gas producers are expected to raise spending by more than 50 percent.

Even before the planned increases in capital spending, non-OPEC production was set to increase in 2017 from new production coming online from long-planned projects, especially from Brazil and Canada, which will add a combined 400 kb/d to supply. Partially offsetting higher production elsewhere, China’s output is forecast to fall by 250 kb/d this year, following a more than 300 kb/d decline in 2016, as state-owned producers continue to curb spending and close wells at mature oil fields deemed too expensive to operate, the IEA noted in its January report.

Untethered Shale Oil Rebound

Market focus, however, is now squarely focused on the pace and scope of recovery in shale output, also called tight oil in the United States, given its singular potential to upend OPEC’s strategy. The IEA, as well as many industry analysts, recently revised its projections for U.S. shale oil production higher on a combination of increased spending by U.S. exploration and production companies, a stronger and faster than expected escalation in drilling activity, and continued improvement in operating efficiencies and well-level productivity. After declining by around 280 kb/d in 2016, the IEA now sees tight oil production rising steadily throughout the year, rising by just over 500 kb/d from the end of 2016 to the end of 2017 with annual increase pegged at 170 kb/d.

Despite recent upward revisions, there is considerable market debate over the potential scope and pace of recovery, with speculation rife that there will be a more robust rebound in U.S. tight oil than expected. Because the resilience of U.S. shale oil has defied market expectations, it has led to flawed analysis. Cutting-edge technological advances and innovative applications used to sharply reduce production costs and improve oil field recovery rates, coupled with hundreds of different companies operating the wells, has, not surprisingly, made forecasting production levels problematic, confounding analysts.

As a result, industry estimates for an increase in shale oil production range from around 200 kb/d to as much as 1 mb/d if oil prices breach the $60/bbl mark. However, the economics of shale plays vary widely, with marginal per barrel costs in a broad $40-65/bbl range. Producers are expected to focus on developing premium producing assets, especially in the Permian Basin, while more expensive, uneconomic wells will remain shut-in until prices reach $65/bbl.

Near term, tight oil production may get a boost as companies prioritize spending on increasing output from completion of already drilled but uncompleted wells, known as DUCs. The significant inventory of DUCs, or the frack log, is unique to shale oil operations and represents a new source of ready supply since, on paper, it can be brought to market within a month. Shale oil producers typically have long-term contracts for drilling rigs. When prices started plummeting in mid-2014, many of the wells became unprofitable so companies maintained drilling to meet contract obligations but stopped short of undertaking the more expensive fracking process, which accounts for roughly 60 percent of the per well costs, due to cash constraints. A large portion of U.S. shale producers only undertake the drilling operations and hire specialized oil service companies to perform the more complex and costly fracking and completion of the wells.

Approximately 250-400 kb/d of DUC wells could theoretically be brought into production within a month at prices above $50/bbl but bringing the wells full cycle is now constrained by the severe staff layoffs at oil service companies, which makes the timing of any new production uncertain. Moreover, oil service companies are arguing they suffered a disproportionate loss of income during the price plunge and are demanding operators pay much higher fees for their services, which has led to protracted negotiations and further delays. Indeed, newly cash-flush producers have stepped up drilling activity but the standoff with oil service firms has led to a steep rise in the frack log. The inventory of DUCs has increased by just over 300 from the August 2016 low of 5,075, with more than 230 wells drilled in the last two months of 2016, according to latest data from the U.S. Energy Information Administration.

The steady rise in U.S. drilling activity over the past six months has also rattled markets and led to speculation that shale output is being underestimated. The number of rigs in operation surged by around 70 percent from the low point of 404 in May 2016 to 694 by January 20, 2017, according to Baker Hughes. Moreover, well productivity significantly improved in 2016, with production per rig rising by around 40 percent at the prolific Permian and Bakken fields.

Uncertainties Cast Clouds Over Outlook

When it comes to upstart shale oil, history is not a very accurate guide to future production trends. After underestimating the resilience of shale in the lower oil price environment, analysts caution that many of the efficiency gains have been made already and that higher per well costs will cap the growth in output. Moreover, in recent years, companies have focused their efforts on the most prolific, premium plays like the Permian Basin and the catalogue of other assets is costlier and more difficult to develop. Approximately 90 percent of U.S. tight oil is located in six plays and there are very few unexplored “sweet spots” remaining, according to one expert.

The time cycle needed to bring new wells online is now at least five to six months, which means most of the increase in supply will take place in the second half of 2017, when demand is expected to surge by a steep 1.4 mb/d above levels posted in the first half of the year. Even assuming a middle of the range increase of 500 kb/d for shale production this year, higher demand will more than offset the rise and lead to a significant drawdown in inventories.

Despite the strong recovery in oil prices over the past two months, a more balanced outlook critically hinges on two key issues: the scale and pace of the recovery in shale oil production, and compliance by OPEC and key non-OPEC producers with new output targets. Indeed, the more bullish oil market outlook may yet be upended by the countries that are party to the agreement. During the first gathering of the Joint OPEC-Non-OPEC Ministerial Monitoring Committee, officials agreed to set up a technical committee that would be charged with monitoring production levels and compiling data, which will then be presented to the ministerial monitoring committee after the 17th of every month, according to the OPEC Secretariat. The committee plans to hold two meetings ahead of the May 25 OPEC meeting in Vienna, with the next one scheduled for March in Kuwait.

While OPEC officials extolled the very preliminary production cuts made so far in January, more public verifiable production data will not emerge until the beginning of February at the earliest. Market analysts will closely scrutinize new data to verify lower production levels and watch for signs of further production cuts by the other countries pledged to reduce output, especially Russia. OPEC has a history of strong compliance with its agreements in the beginning but members’ resolve weakens over time, especially if prices strengthen. Only weeks into the new six-month production agreements, it is far too early to predict whether the current stronger market and higher price levels are sustainable through the year.