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Analysis

Opec's rebalancing act

by Rabah Arezki and Akito Matsumoto

Opec's rebalancing act

 

In November 2014 the Organisation of the Petroleum Exporting Countries decided to maintain output despite a perceived global oil glut. The result was a steep decline in oil prices. Two years later Opec took a different tack and committed to a six-month, 1.2m b/d reduction in crude oil output, effective from January 2017. This led to a small price increase and some price stability that has persisted since November.

The resulting period of respite may be temporary. The price increase is likely to stimulate other oil production projects which can come on line quickly. A recent sharp decline in prices owing to higher than expected oil inventories in the US underscores the liminality of the Opec agreement.

An ineffective agreement
Saudi Arabia, Iraq, the United Arab Emirates and Kuwait are bearing the brunt of the Opec cuts, which could be extended another six months. Other member countries, such as Nigeria and Libya, have been exempted. Several non-Opec producers joined in and agreed to cut around 600,000 b/d. Russia committed to cut 300,000 b/d, and 10 other countries agreed to cut the remaining 300,000 b/d.

These agreements appear to have brought supply and demand into balance at a price just above $50 per barrel. This is largely because of the high degree of compliance by Opec members with the agreed level of production, which the organisation reported was close to 90% in January. This level stands in sharp contrast to the typically low adherence by Opec members to past production agreements. Some reports suggest that compliance is lower, but Saudi Arabia (by far the organisation’s largest producer) has signalled it will do whatever it takes to enhance the credibility of the agreement and has cut its production more than required.

However, there are several threats to the effectiveness of the agreement. Some Opec members – Iran, Libya and Nigeria – have increased their production since October. Furthermore, not only did non-Opec producers make smaller reductions than member states, they also do not have to reach lower production targets as quickly. Russia has so far cut 120,000 of the 300,000 b/d it promised. Several analysts posit that some of the targeted reductions are phantom, reflecting a natural decline from historically high production levels, rather than active cuts.

Shale threat
But perhaps the biggest threat to the attempt to achieve price stability comes from shale oil producers. The $6 per barrel increase in spot oil prices that followed September’s suggestion of an Opec agreement is expected to stimulate investment in oil production in 2017, after significant declines in the previous two years. An increase in shale oil output in the US could quickly offset much of the actual Opec and non-Opec production cuts, because shale wells can begin production within a year of the initial investment. Conventional oil investments, in comparison, take several years to come to fruition.

The shale effect has happened before. In early 2014, even though excess supply was developing, oil prices remained at around $100 per barrel because market participants expected Opec to cut production to support prices. This created a floor price that stimulated non-Opec production of not only shale oil, but oil from relatively high-cost sources as well. The floor price did not last long, owing to oversupply. As a result, oil prices began to fall, precipitously so after the Opec November 2014 meeting.

Despite Opec’s ability to sustain its production agreement, a somewhat similar sequence of events is likely to occur because of shale oil’s responsiveness to price changes. US shale oil investment declined sharply following the fall in oil prices that started in 2014 and, within a few months, production declined. The oil price rebound in 2016 helped boost investment, which was further enhanced by the announcement in September 2016 in Algeria that Opec intended to cut production levels. By February, US oil investment, as measured by the number of drilling rigs in operation, reached its highest level since November 2015.

Rebalancing the market
Moreover, the shale oil threat is greater because producers in the US have become more efficient thanks to improved operations and increased selectivity in the wells they exploit. Although the ultimate capacity of shale oil production is uncertain, its behaviour is now a central feature of the new oil market and will help lead to less volatile production and price cycles.

The Opec agreement has hastened the rebalancing of the oil market, that is, when the supply of oil is in line with demand and accompanied by stable prices. The production agreement should reduce excess supply, at least temporarily. But the futures market in oil prices suggests that expectations are firmly anchored at around $50 per barrel. The forces unleashed by the Opec agreement will limit its effectiveness for the next few years.

Arezki Chart

Rabah Arezki is Chief of the Commodities Unit, Research Department, and Akito Matsumoto is Economist in the Commodities Unit, Research Department, at the International Monetary Fund.

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