Crude oil prices plummeted from more than US$110 per barrel in the second quarter of 2014 to just above US$26 per barrel in the first quarter of 2016. This was due to massive supply additions by tight oil producers followed by ramp-ups by major producer-countries such as Saudi Arabia and Russia. The global crude oil imbalance ─ excess of supply over demand ─ exceeded a staggering 2 million barrels per day (bpd) by the second quarter of 2015, exerting downward pressures on prices. Market speculations about the necessary trigger for a global rebalancing grew rife. Large supply outages early last year, which bore such ascription proved false.
With proceeds buffeted by a protracted low-price regime, major oil-producing countries ─ excluding the United States ─ agreed late last year to cut production, effective January 2017 and rein-in the supply overhang. The agreement provided for a total supply cut of 1.8 million bpd for the first six months of 2017 with the option of a rollover for a further six months. The Organization of the Petroleum Exporting Countries, OPEC ─ excluding Nigeria and Libya, both of which had and still have issues of domestic unrest ─ agreed to a supply cut of 1.2 million bpd while for the eleven non-OPEC countries, the agreed cut was 600,000 bpd.
For both investors and analysts alike, three issues underscore concerns about the accord’s capacity to rebalance the global oil market:
First, a record of breaches of assigned production quotas among OPEC members; second, the lack of an effective mechanism for enforcement of such production quotas; and finally, the effect on prices, of rebounding production, especially among the nimbler United States shale producers.
It is really no secret that some OPEC countries have often violated their production quotas with little or no effective sanctions applied. A report by World Oil for example, showed that even with a supply reduction agreement in place, crude oil shipments by OPEC member Iraq, increased during the first 15 days of February by 122,000 bpd over the average for January. While this could be counterbalanced by reductions in subsequent months, it only accentuates concerns about compliance.
However, due perhaps to the magnitude of the afore-mentioned slump in proceeds, the compliance rate for OPEC under that November accord was high for the first month. Per a report by Argus, the group reduced output by 1.14 million bpd out of the agreed target of 1.17 million bpd (a 97% compliance rate) between December 2016 and January 2017; Saudi Arabia exceeded its agreed reduction quota by 16%. For non-OPEC members, that rate was less than 50%. That said, whether a significant compliance rate among the groups can be sustained, remains to be seen.
Global crude oil prices have ticked up by about 20% since the accord was reached.
With the gradual increase in oil prices, physical traders that made immense profit from contango ─ having bought and stored large, spot cargoes at huge discounts during the price slump and locked-in higher futures values ─ would now have to trim profit expectations.
Also with the uptick in oil prices, many previously offline production facilities, especially in the U.S. tight oil sector are revving up for a restart. During the crunch of low-price regime, many shale oil producers were forced offline (some of them permanently), but some managed to stay afloat by significantly reducing their breakeven prices through structural and operational processes. The structural process entailed drilling almost entirely in high-yield formations ─ a process often referred to as high grading ─ while the operational process entailed enhanced drilling methods as well as benefits from lower overhead (materials, services, personnel etc.) costs.
The Permian basin is currently the most prolific of U.S. production zones and last year recorded one of the highest Mergers and Acquisition values. Major producers are currently shedding non-Permian assets to free-up investment funds for the basin. ExxonMobil for example, is seeking to double its Permian basin assets. But as the demand for these acreages has been rising, so have the asking prices, eating into operating margins.
As global oil prices rise however, so would breakeven costs among these shale producers ─ overhead costs would rise and other lower-yield production basins would come into play. Shale oil output in the U.S. has been on the increase; rig count has increased by almost 50% over the past six months. However, that increase in output would most probably be constrained by fundamental and fiscal issues.
Fundamentals are crucial to the stability of oil prices. A surge in global oil supply for example, would undercut that OPEC-led rebalancing measure and exert downward pressures on oil prices; and lower prices would be a disincentive to such higher-cost producers as those in the lower-yield basins.
Many shale oil producers in the U.S. in the wake of the November OPEC-led accord rushed to hedge their production for 2017 and 2018 at about US$50/bbl, which, given current prices may translate to increased production. Some analysts expect U.S. shale output to increase by 300,000 – 400,000 bpd this year.
In addition, OPEC members Nigeria and Libya, which were not party to the accord are now seeing increased output, though situations there are still tenuous. A significant increase from these producers would mitigate the rebalancing measures intended by that November accord. Nigeria’s output for January for example, was 1.6 million bpd, up from 1.4 million bpd in December, while Libya’s rose 170,000 bpd to about 700,000 bpd. Both countries expect to further increase output in the coming months.
Financial constraints may also weigh-in on U.S. shale oil output. Many investors were severely impacted by the ‘‘shale bust’’ which saw quite a few operators go bankrupt between 2014 and 2016, and would be very wary of another plunge into the shale business. Further, the high-yield instruments which financed a lot of those lapsed operators may find little incentive in the wake of the U.S. Federal Reserve’s recent decision.
The global crude oil balance presents a rather tenuous scenario at least in the short-to-medium term. For example, while December 2016 end-stocks among the Organization for Economic Cooperation and Development (OECD) countries fell under 3 billion barrels for the first time since 2015, stocks in emerging economies such as China continue to build, as have volumes at sea. According to U.S. Energy Information Administration, EIA, in the week to February 10, U.S. crude inventories rose 9.5 million barrels over the earlier week level to 518.1 million barrels, the highest weekly data since 1982. That value was significantly more than analysts’ expectation of only a 3.5 million-barrel increase while the inventory level was 45.3 million barrels higher than the year-ago level.
Some analysts hold that supply cuts provided for by the OPEC-led accord would be inadequate for rebalancing the oil market in 2017, however, the EIA projects a complete rebalancing in 2017; aided perhaps by the higher 3Q ─ driving season ─ demand as well as supply withdrawals by Middle Eastern countries for extra power generation. Temperatures in the region often exceed 40oC during those months, necessitating additional air-conditioning requirements.
With only a mild global economic growth projected for 2017, it is unclear if there would be a significant oil demand growth to eat into the large stock levels and hasten rebalancing.
All said, the crude oil producers’ accord of November 2016 has brought a semblance ─ even if short-term ─ of stability in the oil market. However, the probability of a sustained net-supply to the global stock as well as questions about accord compliance, have cast a pall of uncertainty over the global oil rebalancing.