The last barrel

After two long months of toing and froing, OPEC delivered the news that was all but guaranteed to spread some Christmas cheer across the oil patch. Critics had all but written off the idea of an OPEC production cut, when the Vienna-based group announced cuts amounting to 1.25 MMbopd. And in a move that gave the agreement a good deal more credibility, the group even detailed future production levels and how much each member would be expected to cut.

The news sent crude prices on a tear, and put many an oil man into a festive mood. However, lest we get carried away, the deal may sound sweeter than it is, and it will face a number of challenges, both internal and external, in the months ahead.   

The details. According to the deal, OPEC has agreed to a collective production ceiling—which is effective for six months and, thereafter, extendable for another six months—of 32.5 MMbopd—the lower end of the range that was proposed in Algiers at the end of September.

As would be expected, Saudi Arabia, the group’s de facto leader, will bear the lion’s share of the cuts, with a daily reduction of 486,000 bbl. So, as of January, the Kingdom will pump 10.058 MMbpd. While the proposed ceiling represents a significant cut from recent months, it is less impressive when compared to the Kingdom’s production in January 2016 (10.128 MMbopd), 2015 (9.680 MMbopd ) and 2014 (9.727 MMbpd).

The bulk of the remaining cuts will be borne by Iraq, the United Arab Emirates and Kuwait, which have agreed to make cuts of 210,000 bopd, 139,000 bopd and 131,000 bopd, respectively. However, Iran, which returned to the market in force earlier this year, will be allowed to increase its production 90,000 bopd—yielding a group-wide, net production cut of 1.16 MMbopd. Moreover, the group also reported an “understanding” with “key non-OPEC countries” for an additional reduction of 600,000 bopd. Russia, for example, is said to be prepared to cut 300,000 bopd from its own production.

Will it work? Commenting in the aftermath of the deal, Andrew Slaughter, executive director, Deloitte Center for Energy Solutions, said, “If OPEC cuts to the full amount announced, and maintains those cuts for an extended period, the inventory overhang could be largely brought down to historical levels by August of 2017. Additional cuts by non-OPEC producers would accelerate this rundown in inventories.”

Now, given the continued overhang in oil inventories, which has risen to more than 300 MMbbl above historical averages, there can be no doubt that the cuts are needed—badly needed. However, it’s also worth noting that the agreement comes with some major caveats.

While we are all glad to see the back of OPEC’s pump-at-will policy, serious concerns persist about the reliability of the participating nations. Speaking about OPEC during an event in Washington, D.C., former Saudi Arabian Oil Minister Ali al-Naimi said, “The only tool they have is to constrain production. The unfortunate part is we tend to cheat.” Al-Naimi also expressed skepticism about Russia’s willingness to follow through with its own cuts. “Will Russia cut 300,000? I don’t know. In the past, they didn’t.”

Meanwhile, Indonesia, which rejoined the organization after a seven-year hiatus, has now suspended its OPEC membership. In other words, at the stroke of a pen, OPEC’s collective output was cut substantially, and the nation’s future production, which stood at 722,000 bopd in October, will now be counted apart from the group. Were it not for Indonesia’s suspended membership, an act which created rather a lot of wiggle room for the other member nations, OPEC would have had to cut even deeper or settle for a higher ceiling.

It’s also worth remembering that both Libya and Nigeria, both of which have been increasing production recently, are exempt from the agreement. Libya, for example, increased production from 270,000 bopd in August to 528,000 bopd in October, while Nigeria rose from 1.419 MMbopd to 1.628 MMbopd. And, according to ESAI Energy, the two nations could increase production “by a combined 550,000 bopd between November and the end of the first quarter of 2017.” If that prediction proves to be true, it could easily throw a spanner into the works.

The U.S. angle. The other major wildcard, which cannot be discarded easily, is U.S. shale, which, while bruised and battered, has beaten off all attempts to subdue it. “A number of U.S. E&P CEOs have stated that they will be looking for sustained prices in the $55-to-$60 range, in order to ramp up capital investment,” said Deloitte’s Slaughter. “The result of this OPEC meeting is an important step back to this price environment.”

He added, “Companies with attractive drilling inventories, particularly of DUC wells and strong balance sheets, will be early movers to refresh capital spending.” Lower-cost basins, like the Permian, will be the first to see any new activity, and thus will set the barometer for the response of U.S. producers.

Let’s assume for a moment that the various OPEC and non-OPEC nations stick to their new production targets—at least initially. One has to wonder how some of the more cash-strapped nations will be feeling after a couple of months. Indeed, how will collective discipline hold up, if U.S. operators begin to add rigs and complete DUCs steadily over the next six months? At the very least, OPEC’s proposed output cut could ensure that U.S. production levels out. More than likely, it could even see an upswing toward the end of the initial six-month agreement. How would that be received? Not well, one imagines.

So, while the agreed cuts are a step in the right direction, we aren’t out of the woods yet.