Global oil prices opened the new year on a high note, reaching three-year peaks by mid-January, spurred on by robust winter demand growth, supply outages, and the strong commitment by OPEC and its non-OPEC partners to maintain production curbs through the end of 2018. Oil prices have increased around 10 percent since the producer alliance extended its pact to rein in supplies for the full year. Benchmark prices are currently a steep 25 percent higher than average 2017 levels, with international Brent crude trading at around $68-70 per barrel (/bbl) and U.S. West Texas Intermediate (WTI) in a $62-64/bbl range.

While the strong start to 2018 is a welcome development for producers, OPEC is also mindful that prices ebb and flow on any number of factors, from seasonal demand and supply disruptions to escalating political risks, and this year is no different. Benchmark crude prices traded in an annual range of $18-22/ in 2017 and an even wider $30/bbl in 2016.

The rise in prices prompted some analysts to speculate that OPEC and its non-OPEC counterparts would consider an early end to the production pact at the first meeting of the year of the Joint Ministerial Monitoring Committee in Muscat on January 21. However, the group took a more pragmatic, longer-term view and noted that, despite the recent acceleration in the drawdown in global inventories amid stronger fundamentals, they did not expect to reach their target of reducing stocks to the five-year average until the end of the year. “I don’t think that we are going to reach our target anytime soon, certainly not in the first half [of the year],” asserted Saudi Arabia’s Minister of Energy, Industry, and Mineral Resources Khalid al-Falih. He continued, “We are entering a low demand period seasonally, and we have to let that pass and see how inventories look in the second half before we consider any alteration” to current policy.

Indeed, Saudi and Russian officials not only reaffirmed their commitment to maintain cuts in 2018 but, for the first time, confirmed that they plan to continue working together in 2019. “As we approach the re-balancing by the end of 2018, we need to extend the framework but not necessarily in the production levels,” Falih said in Oman, adding, “We’re uncertain that the pace of inventory drawdown will continue in coming months.”

Oil Stock Drawdown Set to Reverse Course in the First Quarter of 2018

Global inventories continued to contract in the fourth quarter of 2017, according to the International Energy Agency’s (IEA) latest monthly Oil Market Report. OECD inventories at the end of November 2017 were pegged at 90 million barrels above the five-year average, down from 320 million barrels in January 2017 and a peak of 366 million barrels in July 2016. OECD commercial stocks declined for the fourth consecutive month in November, by 17.9 million barrels, with a large fall in heating oil inventories. Commercial oil inventories declined just over 70 percent from January to November, according to IEA data. Preliminary data for December indicate stocks fell a further 42.7 million barrels, or a sharp 1.4 million barrels per day (mb/d).

However, after declining each quarter in 2017, the latest supply and demand data indicate that commercial oil inventories are expected to reverse course and increase in the first quarter of 2018 amid seasonally weaker demand. The IEA sees a build of 330,000 barrels per day (kb/d) on average in the first quarter. That compares with an annual decline of just over 500 kb/d in 2017. The IEA noted “the market is likely to balance for the year as a whole with the first half in a modest surplus and the second half in a modest deficit.”

Strong Economic Growth Fuels Oil Demand

Global oil demand growth has been a key driver of stronger oil prices. The IEA is forecasting growth of 1.3 mb/d in 2018 while OPEC’s higher forecast of 1.5 mb/d is more representative of industry forecasts. The IEA marginally increased its projections for demand growth to 1.6 mb/d for 2017 and left its 2018 forecast unchanged at 1.3 mb/d to 99.1 mb/d. The IEA noted that the growth estimate is “conservative” but that the slowdown in 2018 is mainly due to the impact of higher oil prices. The agency said that weather assumptions have been significantly changed to reflect unexpectedly cold weather, but that the corresponding increase in demand estimates were offset by the higher Brent futures curve used for its price assumption and values had increased by $3.15/bbl compared to its previous forecast.

By contrast, the OPEC Secretariat raised its demand growth expectations this month to slightly more than 1.5 mb/d in 2018, which is more in line with industry forecasts. An accelerating macroeconomic backdrop in the final months of 2017 in the United States, Eurozone, and China has been especially supportive of oil demand growth. The OPEC Secretariat’s Monthly Oil Market Report noted that strong global economic growth of 3.7 percent was supporting robust demand and the ongoing synchronized expansion across the world could lead to further upward revisions. Indeed, there is a growing consensus that forecasts will soon be revised higher on rapidly expanding key indicators.

Crucially, the IEA and OPEC differ sharply on oil demand growth in the first half of the year. While the IEA sees growth of just 1 mb/d, OPEC sees a stronger 1.5 mb/d, a significant 500 kb/d difference. The wide discrepancy, in part, explains why the IEA sees a build in global oil stocks in the first half while OPEC sees a continued drawdown. Differing forecasts for non-OPEC production is the other part of the equation.

No Consensus on Non-OPEC Supply Growth

The IEA and OPEC both made significant upward revisions to their forecasts for non-OPEC supply increases but a major discrepancy between the level of growth remains. OPEC raised its outlook for non-OPEC supply growth by 160 kb/d to 1.15 mb/d due to expectations that higher prices would lead to increased production of U.S. shale oil. At the same time, the IEA increased non-OPEC supply growth by 100 kb/d to 1.7 mb/d, with U.S. production forecast to rise by 260 kb/d to 1.1 mb/d in 2018. The IEA’s higher forecast for non-OPEC supply is more in line with the industry consensus. OPEC and the IEA have similar growth rates forecast for the United States with the discrepancy of some 500 kb/d scattered through other non-OPEC producers.

In its monthly Short-Term Energy Outlook, the U.S. Energy Information Administration increased its forecast for domestic oil production by almost 200 kb/d and growth is now projected to increase by almost 1 mb/d to 10.3 mb/d in 2018, which would be the highest level on record. In its first forecast for 2019, production is projected to rise by a further 500 kb/d to an average of 10.8 mb/d.

OPEC’s Stellar Report Card

OPEC production for its 14 members rose marginally in December 2017, up a small 40 kb/d to 32.4 mb/d, attributed to higher output from Nigeria, according to the OPEC Secretariat. For the 12 countries party to the production agreement reached in Vienna in late 2016, however, supplies declined a modest 30 kb/d to 29.6 mb/d. December production for the OPEC-12 represented compliance of 129 percent, the highest monthly level of conformity in 2017, according the OPEC Secretariat in its monthly report. The Vienna pact calls for 12 of OPEC’s 14 members, with Nigeria and Libya exempted due to ongoing civil unrest, to reduce production by 1.2 mb/d and for 10 non-OPEC producers to cut oil output by 550 kb/d. The new producer alliance has agreed to implement cuts of a combined 1.8 mb/d from January 1, 2016 through the end of 2018.

For the full year of 2017, the OPEC-12 reduced production on average by 1.2 mb/d, on target with its pledged cut and resulting in compliance of just over 100 percent. The non-OPEC contingent cut supplies by an average 450 kb/d for a compliance level of 82 percent for the year. Despite OPEC’s strong conformity level, the implementation of the cuts remained uneven, with the group’s overachievers removing an extra 200 kb/d in 2017, offsetting the underachievers, which collectively overproduced by 180 kb/d. Nonetheless, OPEC’s stellar report card for 2017 exceeded the market’s initial expectations and set the stage for continued strong compliance in 2018.

Notably, the United Arab Emirates reined in production to its formal target level in December after exceeding its quota for most of 2017, but its overall compliance rate for the year was around 70 percent. The country took over the OPEC presidency effective January 2018. However, Iraq remained the largest quota buster, overproducing by around 100 kb/d in 2017. Saudi Arabia, however, reduced production below its target by a corresponding amount.

While multiple supply and demand variables will no doubt be revised higher and lower as the year progresses, there is little doubt that OPEC’s market management approach to supplies will lead to a rebalancing and continued oil price strength in 2018 over 2017 levels. While there are expectations that prices are tipped to come off current lofty levels as seasonally weaker demand sets in late in the first quarter and early in the second, prices are poised to recover in the second half of the year as markets tighten further.

Benchmark crude prices on an annual basis in 2017 averaged around $55/bbl for Brent and $51/bbl for WTI, a steep 25 percent increase over 2016 levels. In 2018 the gains are not expected to be as strong, as robust shale production tempers price increases but they are still forecast to rise by $3-5/bbl over 2017 levels. That said, as global inventories continue to contract and markets tighten, geopolitical risks hold the potential to add further upside risks to price levels in 2018.

For OPEC, the Vienna pact has delivered a sharp increase in oil revenue in 2017, which will reinforce the group’s commitment to its production strategy. Higher oil prices more than offset the average 870 kb/d decline in production for all OPEC’s 14 members, with the IEA estimating the group’s oil revenue increased by $362 million per day in 2017.

The key architects of the OPEC and non-OPEC alliance, Saudi Arabia and Russia, reaped the largest financial rewards in 2017. While Saudi Arabia bore the brunt of the OPEC cuts, it also realized the largest increase in oil revenue, posting an additional $100 million per day in 2017. Equally, non-OPEC Russia, which posted the second largest cuts in production, saw its revenue surge an even stronger $117 million per day, according to the IEA.