OPEC delivered on its pledge to rein in crude oil production in January, signaling a promising start to what will certainly be a challenging six months as the group works to accelerate the rebalancing of global stocks and prop up prices. In the first official assessment of production data since the agreement came into effect in January, the OPEC Secretariat reported on February 13 that compliance with production quotas averaged around 90 percent, well above market expectations.

Oil prices have stabilized in a narrow $52-56 per barrel (bbl) range over the past two months after posting a 20 percent increase in the weeks following the historic agreement by OPEC and some key non-OPEC producers to curtail output levels by a combined 1.7 million barrels per day (mb/d) for the first half of 2017. The market was awaiting the release of the first official reports on OPEC production as a key signal of future price direction but, in the event, confirmation of strong compliance with the agreement was largely discounted as traders focused on a wide array of conflicting data, which has essentially kept oil prices stalled in a narrow trading pattern. Price momentum is facing headwinds from a number of weak links in the production agreements and the potential for resurgent shale oil supplies to offset the cuts, with prices in February posting a modest increase of $0.50/bbl over January levels. U.S. West Texas Intermediate is trading around $52.50-$53.50/bbl and international benchmark Brent crude oil at $55-$56/bbl.

While the uncertain outlook for the recovery in shale oil production has vexed oil analysts and traders, OPEC traditionally takes a longer, more measured view of the market and remains steadfast in its expectations that stronger oil demand growth will more than offset the rebound in shale. However, not for the first time, the faster and stronger rise in drilling activity in the United States over the past several months may have taken the group by surprise, prompting OPEC to reassess the ideal Goldilocks price band of $54-58/bbl. That higher range now appears overly ambitious and the current $52-56/bbl is likely a more reasonable band given the initial U.S. supply response to stronger prices. Shale oil appears to be putting a ceiling on oil prices for the time being but confidence in OPEC’s ability to enforce and sustain compliance with lower production levels in the coming months is making the lower end of the range vulnerable to downward price shifts.

Alternative Facts

The first assessments of January production cuts by OPEC of 1.16 mb/d and non-OPEC producers of 560,000 barrels per day (kb/d) at first blush look promising but conflicting estimates for individual countries and incomplete data for many producers are raising questions about the credibility of the reports. OPEC production declined by 1 mb/d to 32.1 mb/d in January, which represents an overall compliance rate of 90 percent, according to both the International Energy Agency (IEA) and the OPEC Secretariat’s report of secondary source data. Beyond the headline number there are several troublesome issues that are raising red flags for the market, including the fact that only four of the 11 countries party to the agreement met their pledged targets. The high compliance level was reached because Saudi Arabia disproportionately produced well below its new output quota, which helped offset weak compliance from others. The only other countries to meet their targets were Kuwait, Qatar, and Angola while Iraq, the United Arab Emirates, and Venezuela actually increased production above their baseline supply levels.

Production estimates from other sources show weaker compliance of 50 to 75 percent. In a separate assessment in the OPEC report based on direct communications from member countries, Saudi Arabia reported output even lower than independent assessments from outside sources, saying production fell to an eight-year low of 9.75 mb/d, or by 800 kb/d. By contrast, Iraq and Iran reported much higher output than the other assessments. Using OPEC members’ data submissions, compliance was a much weaker 50 percent. OPEC publishes two sets of production data, one based on direct communication from individual countries and the other is an average of secondary sources such as consultants and news media. OPEC is using the secondary source production to monitor compliance given a history of poor credibility with data submitted by members. Meanwhile, OPEC production data published by the U.S. Energy Information Administration, which includes Nigeria and Libya, indicate compliance was closer to 75 percent.

The OPEC and non-OPEC agreements to reduce production were reached after long, difficult negotiations and there were serious flaws with the mechanisms used to assign and implement production quotas, not least of which was the creative arithmetic used to reach target levels. Only 11 of OPEC’s 14 members agreed to adopt new production quotas; strife-torn Libya and Nigeria were formally exempted from the cuts while Indonesia opted to suspend its membership rather than participate in the pact. Saudi Arabia insisted on Iran being party to the agreement but to accommodate Tehran’s demand for a quota above its maximum production capacity at the time, some very dubious calculations were used. There were also concerns that other countries would have to sacrifice higher production volumes to offset the resumption of some disrupted supplies from Libya and Nigeria, which could add 200-500 kb/d in the first half of 2017.

Reporting of non-OPEC production typically lags by two months so January data is not yet publicly available, but compliance was preliminary estimated at a much lower 40 percent. Russia reduced production by 100 kb/d, or a third of what it pledged, but from the onset signaled it would phase in the cuts. Official data for other countries will be available in March.

The mixed reporting on OPEC compliance and more complete data for non-OPEC producers will likely be the focus of the next gathering of the formal group designated to track production and compliance levels. At its first meeting in January, the Joint OPEC-Non-OPEC Ministerial Monitoring Committee set up a technical committee charged with monitoring production quotas. It is unclear if a plan is in place to compile verifiable and accurate production figures by its February 22 meeting but greater transparency is needed to convince the market the agreement is credible.

The Bigger Picture

The market’s notorious short-term focus may be clouding the overall more constructive supply and demand fundamentals supporting oil prices. Global oil markets are on track to steadily rebalance throughout the year, with demand outpacing supplies by an average 860 kb/d in the first six months of the year, according to the IEA. That compares with a 600 kb/d stock draw forecast in January. The stronger outlook reflects the sharper than expected cutback in OPEC supplies and continued robust global oil demand growth. If OPEC and non-OPEC countries extend their agreements for the full year, oil inventories could fall by an even sharper 1.4 mb/d in the second half of the year, bringing stocks within the five-year range of 2.7 billion barrels by the end of the third quarter.

Significantly, oil stocks in the fourth quarter of 2016 posted the sharpest decline over the past three years in OECD countries, down nearly 800 kb/d, and by the end of December were below 3 billion barrels for the first time since December 2015, the IEA reported.

Global oil demand growth was revised up for the third consecutive month, to 1.6 mb/d for 2016 and 1.4 mb/d in 2017, due largely to stronger than expected industrial activity in Asia and Europe. Global oil demand is expected to reach a record breaking 98 mb/d in 2017, with China and India providing the lion’s share of the increase. That compares with an average growth rate of 1.2 mb/d over the previous five years.

The outlook for non-OPEC production in 2017 is unchanged from the January report. After declining by a steep 900 kb/d in 2016, supplies are projected to rise by around 400 kb/d on average to 58 mb/d in 2017. Most of the increase will come in the second half of the year, with production flat in the first six months of the year and then rising by 700 kb/d in the last two quarters. Most of the increase in supply will come from the Americas as long-planned projects in Brazil and Canada come onstream and higher spending on shale boosts U.S. production, according to the IEA. Tight oil production is forecast to ramp up over the year, posting a sharp increase of around 500 kb/d from the end of 2016 to the end of 2017, but overall volumes are expected to average 170 kb/d for the year. The back-ended increase in shale reflects the fact that it takes around five to six months to bring new wells online. OPEC is forecasting slightly stronger growth in U.S. shale output of 240 kb/d for 2017 while the U.S. Energy Information Administration is forecasting production will rise by a modest 100 kb/d to 9 mb/d this year with a sharper 500 kb/d rise in 2018.

The industry continues to parse through data on drilling rig activity in the shale oil patch but conflicting data points are making it more difficult for the market to see the forest through the trees. The latest monthly oil market reports are forecasting only relatively modest increases in shale supplies of 100-240 kb/d in 2017. Moreover, much of the growth in non-OPEC supplies, including shale oil, is slated for the second half of the year when demand is projected to surge by a sharp 1.5 mb/d over the seasonally weaker January to June period, which should more than offset the higher levels and lead to a substantial stock drawdown by the third quarter.

The latest supply and demand balances are supportive of stronger markets in 2017 but the first quarter remains vulnerable to downward pressures as the market debates OPEC and non-OPEC producers’ commitment to the new lower targets. The still high level of global oil stocks and the upcoming seasonally slower spring demand period are also tempering the market’s enthusiasm for bidding prices higher.