OPEC and its non-OPEC oil producing counterparts cemented a new era of cooperation at their May 25 meeting in Vienna, reaching a unanimous decision to extend their production agreement aimed at reducing global oil stock levels through March 2018. Initial projections that oil inventories would decline to the five-year average, the index for market stability following the 2014-16 oil price crash, by the end of the second quarter were too ambitious and further undermined by the resurgence of U.S. shale oil production following the historic agreement inked almost six months ago.

Increasingly competitive and innovative U.S. shale oil production is proving a key catalyst in strengthening the newly-formed alliance of OPEC and non-OPEC producers. By underscoring the common interests of oil producing countries, it highlights the need for a dynamic market management policy as they navigate the new world of technology-driven, nonconventional oil that has transformed global markets.

Moreover, Saudi Arabia’s proactive diplomatic engagement with Russia, which laid the foundation for the historic agreement with non-OPEC producers in November 2016, appears more solid than ever, something few industry observers thought possible after the failures of joint efforts in the past. Saudi Arabia’s Deputy Crown Prince Mohammed bin Salman traveled to Moscow on May 30 to meet with Russian President Vladimir Putin, where they publicly affirmed their intention to cooperate. “We’re grateful to you for the idea and for working together on joint actions between OPEC countries and countries outside the cartel,” Putin told the deputy crown prince.

New Calculations

Led by Saudi Minister of Energy, Industry, and Mineral Resources Khalid al-Falih, Russian Minister of Energy Alexander Novak, and OPEC Secretary General Mohammad Sanusi Barkindo, ministers reached a new agreement at the 2nd OPEC and non-OPEC Ministerial Meeting, immediately following the OPEC conference, to extend the 1.8 million barrels per day (mb/d) of cuts for a further nine months. This time frame is based on projections that oil inventories will fall to the five-year average by the end of 2017 or early 2018 at the latest. “All indications are that a nine-month extension is the optimum and should bring [world crude oil inventories] within the target five-year average by the end of the year,” Falih said when announcing the latest agreement.

The market, however, has been underwhelmed by the decision. Plans to extend the cuts into 2018 were widely flagged by ministers in the week leading up to the meeting but nonetheless disappointed analysts, who were looking for either deeper cuts beyond 1.8 mb/d or a longer extension of 12 months, or both. Prices for benchmark crudes Brent and West Texas Intermediate (WTI) dropped by around 5 percent immediately following the announcement. Such overreactions pushing prices up or down following OPEC meetings are not surprising and are almost always temporary in nature as the market digests the implications of such decisions. Futures prices posted a partial recovery after the initial decline but ebbed lower again on mounting market skepticism over the effectiveness of the new deal. The near-term outlook will remain uncertain until solid evidence of a drawdown in global oil stocks emerges in monthly data. Prices for benchmark crudes are trading $3-$3.50 per barrel ($/bbl) lower since the agreement, with WTI last trading at $48.50/bbl and Brent hovering just above $50.50/bbl.

OPEC’s Shale Quagmire

The decision to maintain lower production levels will have some short-term benefits since it will allow more time for the market rebalancing to take hold. Moreover, the peak June to August demand season is just around the corner and expected to accelerate the drawdown in stocks, which should provide support for prices in the near term. Oil traders and market analysts, however, are also focusing on the medium term into 2018, concerned the latest agreement to prolong the cuts has provided further incentive for tech-savvy U.S. producers of shale oil to accelerate drilling activity and production growth, which will negate the positive impact of the cuts and further delay the market rebalancing.

OPEC production has declined on average by 1.3 mb/d in the first four months of the year from end of 2016 levels. Meanwhile, total U.S. oil production has risen by around 400,000 barrels per day (kb/d) over the same period and is on track to increase by 1 mb/d by the end of 2017, according to the latest projections from the Energy Information Administration (EIA). The relentless rise is forecast to continue in 2018, with estimates ranging from 600 kb/d to well over 1 mb/d. The EIA’s latest forecast for total U.S. oil production in 2018 was raised in May by 200 kb/d to 9.9 mb/d, surpassing the previous record level of 9.6 mb/d reached in 1970. The higher prices leading up to the Vienna meeting enabled producers of shale (called tight oil in the United States) to hedge their future output by locking in the stronger prices now for sale later. As much as 1.5 mb/d of new production could be brought online by the end of 2017 and a further 1-1.5 mb/d in 2018, according to more bullish forecasters. When oil prices breached the $45/bbl in May 2016, U.S. producers started ramping up drilling activity, with the numbers of rigs in operation more than doubling in the past 12 months, to over 900 in May. Of that, around 330 rigs have been added since OPEC’s initial November 2016 agreement. Unlike conventional oil projects that can take seven to 10 years to develop, U.S. tight oil production can be brought online in about four months once drilling has started. Some analysts now believe that OPEC has once again underestimated the potential growth in shale and expect a wave of new production to hit the market in 2018.

Short-Term Market Management

Questions were also raised in Vienna about whether the group has an exit strategy for the agreement, with fears that once the group lifts quotas on April 1, 2018 the sudden jump in supplies, along with increased shale production, will again propel global inventories higher and prices lower. The market, however, may be getting ahead of itself as OPEC appears to be taking a more proactive and flexible approach to adapting to changing market conditions. Falih reaffirmed in Vienna that he is prepared to “do whatever it takes” to rebalance the market and few close observers doubt his steadfastness to stay the course. Both Falih and Novak downplayed the importance of outlining an exit strategy now. “Supply from shale is certainly not certain,” Falih said. He added, “What we do and how we do it in second quarter and beyond will be something we decide closer to the date. We certainly don’t intend to abandon market monitoring.” Novak clarified that mechanisms for lifting the lower quotas were discussed but that the group “agreed that there is no reason to speak about it now.” Nonetheless, while telegraphing an exit strategy now may seem very premature to the producing group, OPEC officials may need to address the issue soon in order to shift the current bearish market sentiment to a more bullish one.

The OPEC and non-OPEC alliance of 24 producers largely implemented their new lower production levels on January 1 but compliance with the targets has been uneven, especially from non-OPEC participants. Analysts point to a history of weaker compliance rates over time, fueling further skepticism about the strength of the agreement. OPEC compliance with the agreement has been estimated at over a hundred percent, which is a degree of discipline never reached during previous production accords. OPEC’s high level of compliance, however, has in large part been due to Saudi Arabia making sharper production cuts than required to offset weak adherence by others, especially the United Arab Emirates and Iraq.

Indeed, Iraq is seen as a major weak link in the agreement given its initial resistance, plans to significantly increase production capacity by the end of the year, and poor compliance with the current pact, around 60 percent in the first quarter. Iraq sought an exemption from the accord ahead of the November 2016 meeting, arguing it is shouldering a tremendous financial burden in its battle to defeat the Islamic State in Iraq and the Levant, which benefits neighboring states, but in the end acquiesced to pressure and accepted a lower production quota. However, since then conflicting statements coming from Iraqi officials about the country’s commitment to the agreement have raised alarm bells in the market.

In a pre-emptive effort to avoid an acrimonious debate at the Vienna meetings, Falih made an unexpected trip to Baghdad on May 22 to meet with Iraqi Prime Minister Haider al-Abadi and Oil Minister Jabar Ali al-Luaibi to resolve problems ahead of the formal gathering. Falih secured Iraq’s pledge that it would support the extension of the agreement and fully commit to reduce output to its new lower target. Falih also discussed with Abadi opening new channels of investment, participation in energy projects, economic cooperation, and contributions to the reconstruction of Iraq, which helped secure Baghdad’s support. The last minute Saudi outreach to Baghdad has added a much higher degree of credibility to future Iraqi production levels.

Non-OPEC compliance was much weaker over the January to April period, with estimates ranging from 30-60 percent. Russia only fully lowered its output by the agreed 300 kb/d at the end of April, which should raise the overall compliance level for the non-OPEC participants going forward. By contrast, Kazakhstan has actually increased production by about 50 kb/d and there is little indication that it will reduce production as pledged. Transparency issues have plagued non-OPEC production data. The group’s Market Monitoring Committee does not provide production details on the non-OPEC producers, unlike OPEC, which publishes monthly data of production based on independent assessments by secondary sources. However, Russia matters most given its proportionately higher contribution of more than half the non-OPEC 560 kb/d pledge and the country is now on track to maintain its lower output level, not least because Putin has publicly supported the deal.

Data Dichotomy

Despite much lower OPEC and non-OPEC crude oil production this year, there is still considerable skepticism over whether the agreement to reduce supplies by a collective 1.8 mb/d will be effective or completely undermined by the revival in shale production. Fueling the doubts is an array of tanker data showing a corresponding decline in crude exports has been relatively more modest to date than the production cuts imply. Equally, global oil stocks remain stubbornly above the 3 billion barrel high-water threshold. The data dichotomy explains why the rebalancing process has been much slower than expected. Less than perfect data has always plagued the industry, especially the dearth of information on non-OECD countries, where most of the growth in demand and trade flows is taking place.

Ironically, it is the more transparent and reliable data on U.S. oil stocks and imports that have fueled market angst about the effectiveness of the cuts. Stubbornly high U.S. inventories have remained above the five-year average despite posting declines for seven straight weeks. Stocks levels remain bloated, in part, because Saudi Arabia and other OPEC producers have increased crude shipments to the United States since January, rather than reducing them as expected. Unlike other major consuming regions that do not provide timely data points on oil stocks, production, and imports, the United States provides an unprecedented level of visibility with weekly government and industry reports that unavoidably have a disproportionate impact on international price movements.

In a tactical move aimed at changing the headline numbers undermining confidence in OPEC, Falih announced in Vienna that Aramco will sharply reduce crude exports to its much coveted U.S. customers in the coming weeks in order to help accelerate a stock drawdown in the world’s largest consuming market. “Exports to the U.S. will drop measurably,” Falih said. In the fourth quarter of 2016, Saudi Arabia exported just under 1 mb/d to the United States but volumes jumped to 1.2 mb/d in 2017, according to the EIA. A cut in exports to below 1 mb/d, or an even lower 800-900 kb/d, however, will not have a material impact on supplies until mid-July since transit for tankers from the Gulf region to the United States takes around 40-60 days. The decision to reduce shipments to the United States will provide a visible indicator of declining stocks in a key market, though overall Saudi exports will not be affected since they will likely just shift the barrels to less transparent markets in Europe or Asia.

The Ties That Bind

Despite the legitimate market concerns surrounding the merit of the new agreement, OPEC’s de facto leader Saudi Arabia has shown an unwavering resolve to achieve a more stable and balanced market and a willingness to stay the course in the long term. When Falih took over the oil portfolio a year ago, he immediately embarked on an extraordinary diplomatic outreach to fellow OPEC member states at the June 2, 2016 ministerial meeting, ushering in a renewed sense of unity among the group after years of discord. Diplomatic overtures to his like-minded Russian counterpart, Novak, followed and ushered in an unprecedented level of petro-diplomacy between the Saudi deputy crown prince and Russian president. Falih has argued that an “expanded network of producers with a larger share of global production is the only way to achieve a constructive, stable market for all.”

The Saudi-Russian coordination to stabilize the oil market has not only deterred a price collapse but higher prices have more than offset the lower production levels and delivered significant revenue increases to government coffers. Prices for benchmark Brent have averaged $53.75/bbl this year, which represents a $10/bbl increase above 2016 levels. WTI has averaged $51/bbl this year, a gain of just under $8/bbl from 2016. OPEC’s basket price, a weighted average of representative crudes from member countries, has posted the strongest rebound this year, up on average by $10.50/bbl to $51.25/bbl. The relatively stronger price levels for Middle Eastern crudes ironically stem from the group’s decision to reduce production by targeting medium and heavy crudes, creating a premium for the grades.

Navigating a New Course

At minimum, the nine month extension has bought OPEC and its non-OPEC partners extra time for the production cuts to accelerate the drawdown in global stocks and engineer a shift in the market sentiment. It will also give the group more time to see how the shale oil production curve evolves over the coming months and test the price levels needed to contain shale growth. Following the Vienna meeting, a number of investment banks lowered their oil price forecasts for 2017 and 2018, with closely watched Goldman Sachs arguing that “In the face of rising supply potential from shale, new projects and OPEC, 2018-19 oil futures need to stay at or below $50/bbl to discourage further shale ramp and encourage OPEC to keep a range-bound market share.”

A price range of $50-60/bbl was discussed in Vienna as the ideal level but the group may find they will need to lower their expectations given the U.S. producers’ relentless drive to lower the cost of production. “For all OPEC members, $55/bbl and a maximum of $60/bbl is the goal at this stage,” according to Iranian Oil Minister Bijan Namdar Zanganeh. He added, “So is that price level not high enough to encourage too much shale? It seems it is good for both.” The market will continue to closely monitor the monthly oil reports from the major forecasters for solid data showing a significant stock drawdown is underway in order to establish a new strategic outlook for oil price direction. Meanwhile, OPEC and its non-member producing partners will have to hope that between now and the next ministerial meeting on November 30 a more fully informed view of the market dynamics for shale will emerge.