The oil market is on an unsustainable course with output from U.S. shale and other non-OPEC sources increasing rapidly, while OPEC and its allies trim production to reduce inventories and prop up prices.
The International Energy Agency (IEA) projects non-OPEC output will increase by 1.5 million barrels per day (bpd) in 2018 (“Oil Market Report”, IEA, June 2017).
If that proves correct, non-OPEC suppliers will capture all the increase in demand next year, because the IEA predicts consumption will increase by only 1.4 million bpd.
In effect, OPEC will be restricting its own output only to see rival producers step in to meet growing demand from refiners.
OPEC will face the familiar dilemma of whether to defend oil prices by continuing to restrict output or defend market share by growing production again.
OPEC and its non-OPEC allies are unlikely to remain impassive as U.S. shale producers and other non-OPEC countries not bound by the production agreement capture all the growth in market demand in 2018.
If U.S. shale production continues to grow rapidly, OPEC will probably return to defending its market share in 2018, even if it means accepting lower oil prices.
OPEC’s strategy can best be described as a cycle alternating between prioritising price protection and defending market share.
Between 2012 and the middle of 2014, the organisation’s members complacently enjoyed high prices but ceded market share to the U.S. shale sector and other non-OPEC producers including deepwater projects.
OPEC’s share of the market shrank progressively from 43.5 percent in 2012 to 41.2 percent in 2014, the lowest since 2006, according to BP (“Statistical Review of World Energy”, BP, 2017).
If the shale boom had continued, with U.S. production growing at more than 1 million bpd per year, OPEC’s share would have fallen even further in 2015 and 2016.
So OPEC, under the leadership of Saudi Arabia, refused to cut production and allowed oil prices to fall to curb the shale boom and deepwater projects, which was the only rational strategy under the circumstances.
Between mid-2014 and mid-2016, OPEC’s strategy switched to protecting its market share and allowing oil prices to sink.
OPEC’s market defence strategy appears to have been successful, with its share of output climbing from 41.2 percent in 2014 to 42.7 percent in 2016.
But the cost proved more painful than anticipated, with oil prices slumping from an average of $100 per barrel in 2014 to less than $45 in 2016.
In the second half of 2016, OPEC switched tack again, and abandoned its market share strategy in favour of a return to price defence.
Prices have risen but OPEC’s share of production is set to decline once more in both 2017 and 2018, which could force another change of strategy.
The resurgence of U.S. shale is already complicating OPEC’s efforts to draw down global stocks in 2017, as well as threatening its market share in 2018.
The speed and scale at which U.S. shale production has bounced back from the slump in 2015/16 has confounded OPEC and all the other major forecasters.
OPEC wrote in its latest oil market assessment that rebalancing is underway but at a slower pace because of the “shift in U.S. supply from an expected contraction to positive growth.”
OPEC now predicts U.S. oil production will increase by 800,000 bpd in 2017, compared with a projected decline of 150,000 bpd at the time of its December forecast (“Monthly Oil Market Report”, OPEC, June 2017).
The International Energy Agency is forecasting U.S. crude and condensates production to increase by 620,000 bpd in 2017, compared with a prediction that output would be flat in its November assessment.
And the U.S. Energy Information Administration has raised its prediction for U.S. output growth in 2017 to 460,000 bpd from a predicted decline of 80,000 bpd in December.
STEIN AND SHALE
At this point in the cycle, it may be time for OPEC and U.S. shale drillers to heed Stein’s Law.
“If something cannot continue forever, it will stop,” wrote Herbert Stein, chief economist to U.S. President Richard Nixon.
His law is arguably the most important insight in economics but it is amazing how frequently it is forgotten (“What I think: essays on economics, politics and life”, Stein, 1998).
U.S. oil producers have added more than 400 extra rigs since the end of May 2016 in response to higher oil prices.
But the increase in U.S. production is now threatening to overwhelm the market, in a re-run of the situation in 2014 that led to the price collapse.
The U.S. Energy Information Administration projects U.S. production will rise by a further 680,000 bpd in 2018. The International Energy Agency is predicting an even larger increase.
Most forecasters are bullish about the outlook for oil demand growth in 2018. Even so, output from U.S. shale and other non-OPEC sources will essentially capture the entire gain.
The implied erosion of OPEC’s market share is unlikely to be sustainable, and following Stein’s Law, it will stop.
The correction is likely to come from lower oil prices, which will have to fall low enough for long enough to bring the boom back under control.
Benchmark U.S. crude prices have already declined by $9 per barrel or about 16 percent from their recent peak in the middle of February.
Shale producers have continued to add rigs even as prices have fallen because most of their production for 2017 had already been hedged at higher price levels.
Shale firms have also benefited from plentiful funding from private equity investors with a relatively long-term view on the market.
But most producers have only hedged a relatively low proportion of output for 2018 so far, and the patience of private equity investors will not last forever.
Crude prices will need to remain relatively low until more of the hedges have expired, private equity funding has slowed and drilling moderates to a more sustainable pace.
Many U.S. shale producers insist they can drill wells profitably at prices well below $50 per barrel and in some cases below $40.
There may be an element of bravado in some of these claims which may exclude certain costs and apply only to the most productive wells in the most promising locations.
In any case, the oil market is already testing the shale drillers’ resolve.
Oil prices are likely to remain weak until there are signs that U.S. drilling and future production are shifting onto a more sustainable trajectory.