OPEC faces a new set of questions after winning output cuts from non-members and members of the oil cartel in recent weeks.
Analysts say the potential upside for the deal shouldn’t be played down: Non-OPEC members on Saturday committed to reducing output by 558,000 barrels a day. If implemented, that would amplify the effects of 1.2 million barrels worth of daily cuts from OPEC for the first half of 2017.
But now market watchers are shifting their focus to other questions: Will the producers stick to their promises? Can they keep prices in a narrow range? How much will high-cost U.S. production rise as prices bounce?
In a sign of Saudi Arabia’s commitment to the deal, Energy Minister Khalid al-Falih said OPEC’s top producer could cut deeper than its initial commitment on Nov. 30, Goldman Sachs noted.
“The inclusion of several countries with natural declines has rightfully brought the entire deal into question.” -investment services firm Macquarie, in a research note
“This comment comforts us in our view that Saudi Arabia has a strong economic incentive to cut production to achieve a normalization of inventories at this stage of the oil market rebalancing, even if it requires a larger unilateral cut,” Goldman analysts said in a research note.
But the task of enforcing a 22-nation deal — while simultaneously trying to control prices so in a way that keeps U.S. drillers on the sidelines — could be more than even the Saudis can manage, according to Barclays.
“There are too many moving parts for OPEC’s new policy to be sustainable in the long term. The strategy is bound to overshoot, in our view, leading to lower prices in the second half of next year,” Barclays analysts said in a note.
What follows are some of those moving parts that could trip up the deal.
Cuts that aren’t really cuts
Nearly a dozen non-OPEC producers agreed to cut production, including Azerbaijan, Bahrain, Brunei, Equatorial Guinea, Kazakhstan, Malaysia, Mexico, Oman, Russia, Sudan and South Sudan.
Here’s the problem: Of those 11 nations, eight have mature oil fields that were already expected decline naturally — and perhaps even more so, due to cuts to capital spending in recent years, Barclays noted.
Essentially, OPEC is counting those natural declines toward the cuts. Consequently, some investment banks have not adjusted their forecasts for these producers much.
“The inclusion of several countries with natural declines has rightfully brought the entire deal into question,” Macquarie analyst said in a note. However, even factoring those dubious cuts, the firm said its own analysis indicates that the deal is still meaningful.
Goldman Sachs believes full compliance would add another $6 a barrel to its $55 price forecast for U.S. crude. The problem is that OPEC members have cheated in the past.
The deal sets up a classic prisoners’ dilemma, said Robert McNally, president of energy and geopolitical consultancy The Rapidan Group. The best thing for the group collectively is to cut and stick to the deal as oil prices rise, but the best option for each individual member is to cheat while everyone else stays honest.
The production figures that cartel members provide to OPEC can’t be trusted, and producers can game the system that calculates their output, Barclays said in a note.
For example, third parties arrive at their OPEC production figures in part by estimating how much crude they are refining into fuel, and then adding that estimate to net exports. Under this system, producers can appear to cut production while actually holding it steady by under-reporting refinery activity and tinkering with the mix of petroleum products they export, according to Barclays.
A ‘massive’ response from US frackers
Consensus is forming around the notion that OPEC boss Saudi Arabia is underestimating the opportunity that higher prices will provide to U.S. shale producers.
“Interestingly, many OPEC members have shared the group’s view that U.S. response in 2017 will be limited,” Macquarie analysts said. “Our modeling indicates that U.S. shale response will be massive.”
Many U.S. drillers have higher costs because they rely on hydraulic fracturing — or pumping water, minerals and chemicals into the earth at high pressure to fracture shale rock and release oil and gas. Low oil prices over the last two years have forced deep cuts in U.S. oil production and pushed dozens of drillers into bankruptcy.
Source: U.S. Energy Information Administration
U.S. producers already stood up more rigs in oil fields and locked in higher prices for future crude deliveries as prices rose on speculation OPEC would cut output. Goldman now believes U.S. frackers can raise production by 800,000 barrels a day with oil prices at $55 a barrel, even as they spend little of their cash flow and reduce their debt.
Analysts also recently explained to CNBC how OPEC’s cuts creates an opening for U.S. oil to reach buyers in China.
Even legitimate efforts to cut production could have adverse consequences.
Barclays anticipates some countries will try to achieve cuts by doing maintenance on refineries earlier than planned. That reduces crude demand in the near term, but can lead to more activity when refineries start to back up.
“This means cuts are just going to turn into surges at some later date,” Barclays concluded.
The Russia wildcard
Russia is promising the lion’s share of the non-OPEC cuts — 300,000 barrels a day — but there are already signs the world’s top oil producer is giving itself room to undershoot.
Goldman identifies a few problems with Russia’s final commitment. The cuts will come from a higher-than-expected output in October of 11.247 million barrels a day. Russia has also indicated it will initially only target gradual cuts inching toward 200,000 barrels a day through March. The total promised cuts would come only by the end of the second quarter of 2017.
“As a result, while Russia’s participation is important, the actual impact on the global oil balance of a Russian cut will remain short of the (300,000-barrel) cut headline,” Goldman analysts said.
Problems beyond Russia
OPEC gave Libya and Nigeria a pass on cutting production, because both are trying to restore supply that was sidelined by internal conflict. The situation in both countries remains highly vulnerable, but analysts say a sudden surge in supply from these two countries is a real risk.
Some analysts also see Kazakhstan potentially struggling to stick to its quota. The country just started up a long-delayed, massive Kashagan oil field. Even conservative estimates see it adding 150,000 to 200,000 barrels a day to output.
Lastly, Barclays said a resolution to an ongoing Saudi-Kuwaiti dispute over a jointly operated oil field could offset reductions from the two countries. However, they could delay restarting the project even in the event of diplomatic breakthrough in order to show support for the output cut deal.