OPEC and non-OPEC officials announced their expectation that the rebalancing of oil markets will accelerate in the second half of 2017 as a result of sharply stronger global oil demand growth and pledged to clamp down on member countries violating their production targets at the conclusion of the 4th Meeting of the Joint Ministerial Monitoring Committee in St. Petersburg, Russia July 24. Despite speculation that the committee might recommend deeper production cuts, no changes were made to the Declaration of Joint Cooperation that calls for the 24 countries participating to reduce production by 1.8 million barrels per day (mb/d) from January 2017 to the end of March 2018. This includes extending the quota exemptions Libya and Nigeria currently enjoy.

Perhaps recognizing the meeting would fall short of market expectations and exacerbate the prevailing bearish sentiment, Saudi Arabia’s Minister of Energy, Industry, and Mineral Resources Khalid al-Falih, who is also OPEC’s current president, announced following the meeting that the kingdom was also planning to unilaterally reduce crude oil exports in August to help hasten the rebalancing of markets. Saudi crude oil exports will be capped at 6.6 mb/d in August, roughly 600,000 barrels per day (kb/d) below year ago levels. Though lower Saudi crude exports for August have already been widely flagged in the market, Falih’s official announcement proved popular with traders who bid oil prices marginally higher in response. After plunging to six-month lows on June 23, oil prices have since ebbed and flowed and have posted only a modest recovery of about $0.75 per barrel ($/bbl) so far in July over average June levels. Benchmark crudes are still a steep $8.50/bbl below their 2017 peak levels. International Brent was last trading around $48.50/bbl and U.S. West Texas Intermediate (WTI) at $46.14/bbl.

Market Fundamentals on Track to Strengthen

Mirroring the conclusions of experts at the St. Petersburg meeting, a much more supportive outlook for global oil supply and supply fundamentals is forecast for the remainder of 2017, according to the July Oil Market Report from the International Energy Agency (IEA). Its latest forecast reinforced long held expectations that global oil demand will sharply outpace supply growth in the second half of the year and, at last, trigger the long awaited drawdown in bloated stock levels that have pressured prices lower for the past three years. Stronger global oil demand growth in the second half of the year could help eliminate two-thirds of surplus inventories by the end of 2017 but the massive inventory surplus built up over the past few years will need to be totally cleared from the market before a sustained increase in oil prices to a higher $55-60/bbl range takes hold.

After many false dawns, however, traders remain wary and are waiting for solid data to confirm the market is rebalancing. The IEA’s July 13 report noted that preliminary data signal a drawdown in stocks is already under way but, at the same time, cautioned that stock data for the second quarter of 2017 is still incomplete. Adding further downward pressure, the IEA reported OPEC production in June was at its highest level this year, with a corresponding decline in compliance levels. While the IEA report struck a cautious tone on the latest data, the OPEC Secretariat‘s monthly report released on July 12 was considerably more pessimistic on the outlook for 2017 and 2018.

With confidence in OPEC’s ability to manage the market wavering and the rise in non-OPEC production continuing apace, investment banks and other forecasting agencies have lowered their price forecasts for 2017 and 2018. The U.S. Energy Information Administration (EIA) reduced its forecast for Brent crude oil prices to an average of $51/bbl in 2017 and $52/bbl in 2018, $2/bbl and $4/bbl lower than June’s projections. WTI is forecast to be $2/bbl lower than Brent price for both years.

Near-Term Strength Overshadowed by Weaker 2018 Outlook

While a more balanced market is expected to emerge for the remainder of 2017, the underlying bearish market sentiment in part reflects a weaker outlook in 2018, when supply is forecast to once again outpace demand. Assuming average OPEC production of 32.4 mb/d in the second half of 2017, the implied stock draw is now projected at a steep 1.1 mb/d for the third and fourth quarters, which equates to just under 200 million barrels.

OPEC and its non-OPEC partners have cut production in a bid to reduce OECD inventories to the five-year average of approximately 2.7 billion barrels. The latest data show the inventory overhang declined to around 265 million barrels in May from 300 million barrels in April, and a further decline is projected for June. However, oil stocks look set to resume an upward trajectory in early 2018 as rising supply eclipses seasonally weaker demand. Current projections, assuming average OPEC production of 32.7 mb/d, signal an inventory build of 250,000 (kb/d) in the first six months of 2018 before contracting again by an estimated 450 kb/d from July to December.

The IEA revised up global oil demand growth by 100 kb/d, to an average 1.4 mb/d for 2017 and 2018, to 98 mb/d and 99.4 mb/d, respectively. Significantly, global oil demand is forecast to increase to an average 99 mb/d in the second half of 2017, up by a substantial 2 mb/d over the average 96.9 mb/d posted from January to June. The Joint OPEC-Non-OPEC Technical Committee told officials in St. Petersburg that it also sees strong growth in the second half of 2017 compared to the first half, “with the growth reaching a level of 2 mb/d, which should sustain the inventory draws.”

Qatar Jet Fuel Demand Hit by Embargo

The embargo on Qatar, especially the ban on use of its Gulf neighbors’ air space, has led to a sharp downturn in oil demand for the past two months, especially for jet fuel oil. The IEA reported jet fuel and kerosene demand declined by 35 kb/d in April from a year earlier, more than offsetting gains in other products. Total oil demand in Qatar is currently forecast to remain flat in 2017 at 305 kb/d, resuming growth toward the end of 2018, but this outlook is subject to downside risks depending on the duration of the diplomatic crisis.

U.S. Oil Production Drives Non-OPEC Growth

Partially offsetting stronger demand growth, non-OPEC supply is also forecast to strengthen from July to December, rising by 935 kb/d compared to 500 kb/d in the first half of 2017. The IEA’s outlook for non-OPEC supply growth is projected at 700 kb/d on average in 2017 before doubling to 1.4 mb/d in 2018. The United States is the largest source of supply growth at 610 kb/d in 2017 and just over 1 mb/d in 2018. The IEA’s just-released “World Energy Investment Report 2017” estimates spending on U.S. shale will increase by a steep 53 percent while overall upstream investments are pegged at just 6 percent in 2017.

The EIA forecasts slightly lower growth in U.S. crude oil production in 2017 and 2018 of 400 kb/d and 600 kb/d, respectively, due to a weaker price outlook. Nonetheless, the EIA’s Short-Term Energy Outlook published July 11 still forecasts production will reach the highest annual average in history in 2018 at 9.9 mb/d.

The inexorable growth in tight oil production has been fueled by increased capital spending, a rebound in rig activity, cost efficiencies, and improvements in well productivity. Significantly, however, the pace of production development in the shale sector appears to be slowing in response to weaker prices during the second quarter of 2017 and a shortage of fracking crews. The EIA’s latest Drilling Productivity Report forecasts tight oil production in the seven major producing regions to rise by 600 kb/d from year ago levels, to a record 5.5 mb/d in July. However, rig additions and productivity per rig have shown a marked slowdown in recent months. The report shows rig additions for the seven regions eased to 79 rigs in the second quarter from 175 added during the first quarter and 252 in the fourth quarter of 2016. Nonetheless, operating rigs in tight oil producing regions are at a record 9,067 compared with 8,281 a year ago.

Surging Fracklog Adds to Tight Oil Growth Next Year

At the same time, the Drilling Productivity Report data show oil production per rig gradually plateauing over the past 12 months, in large part because operators are not able to complete the wells as fast as they drill them due to a shortage of fracking crews. Growth in productivity per rig slowed to just 10 barrels in the second quarter of 2017 compared to over 200 barrels in the second quarter of 2016. As a result, the number of drilled but uncompleted wells (DUCs) has surged 22 percent over the past six months to a record 6,031 in June. Approximately 75 percent of the increase in DUCs for the period is concentrated in the prime Permian Basin in Texas and New Mexico, where uncompleted wells have increased a staggering 58 percent to 2,244 over the past six months.

The massive “fracklog” of wells drilled but not completed signals production will continue growing through the rest of 2017 and into 2018 as wells are completed but it is also sparking fears of adding further downward pressure on prices in 2018. At the same time, current lower oil prices around $45/bbl are also raising the specter of a slowdown in shale oil production growth. Break-even prices for shale development are wide ranging by company and region but prices of $45/bbl and under could “slow most U.S. shale plays,” according to UBS.

OPEC Production Hits 2017 High

OPEC crude oil production in June also unnerved markets after posting the highest supply levels in 2017. Total production for the 14 members, which as of May includes Equatorial Guinea, rose by around 400 kb/d to 32.6 mb/d in June, according to the OPEC Secretariat data based on secondary sources. More than half of the increase came from Libya and Nigeria, which are both exempted from quotas under the new agreement due to ongoing supply disruptions from civil unrest. Libya posted the strongest recovery, rising by 125 kb/d to 850 kb/d, the highest level in four years. By early July, Libyan production reportedly reached 1 mb/d, triggering a major flashpoint for markets concerned that the country’s higher production will offset OPEC cuts in coming months. Similarly, a lull in militant attacks on oil pipeline infrastructure paved the way for a rebound in Nigerian production to around 1.7 mb/d, the highest level since March 2016.

After five months of production well below its quota, Saudi Arabia increased output in June, marginally exceeding its quota by a meager 12 kb/d. Nonetheless, the market focused on quota “busting” by OPEC’s most high profile producer. Saudi Arabia reported it produced 10.1 mb/d in June – around 200 kb/d above May levels. Saudi Arabia historically increases production to meet peak demand at power plants during the summer months. This year demand was exceptionally robust with Ramadan in June.

Falih confirmed in St. Petersburg that the kingdom plans to reduce crude exports sharply by 600 kb/d in August from year ago levels, to 6.6 mb/d, to meet higher domestic demand and still stay within its production target. That compares with average exports of 7.2 mb/d in the first five months of 2017.

Higher OPEC production in June, however, barely made a dent in the average six-month compliance level, which OPEC data indicates was just over 100 percent for the period. The 11 OPEC members participating in the production accord collectively lowered production by 1.2 mb/d from January to June, in line with their commitments under the agreement.

Nonetheless, on an individual country basis some members are falling well short of meeting their obligations, with Iraq, the United Arab Emirates, and Venezuela around 50 percent or less. The Joint Ministerial Monitoring Committee said it plans to work with violators to improve compliance. Ecuador announced it will abandon the agreement altogether due to revenue constraints but as OPEC’s smallest producer, its contribution to the cuts is negligible.

Compelling Arguments for a Further Cut by OPEC

OPEC officials said it was premature to discuss further output cuts in St. Petersburg, preaching patience instead. That said, the latest monthly supply, demand, and stock data indicate that OPEC will fall short of its goal of reducing stock levels to the five-year average by the end of 2017 before inventories start rising again in early 2018.

The group may be forced to consider further cuts at the 5th Meeting of the Joint Ministerial Monitoring Committee, which is scheduled for September but can be moved forward if needed. Historically, OPEC has made additional cuts as the market warrants such as in 2008, when quotas were lowered at three successive meetings in order to strike the right market balance. Whether OPEC can find a formula that will satisfy its members (and non-OPEC members) who signed on to the production accord is the challenge that lies ahead.