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What can Opec do?

The supply deal is stuck in limbo—the cutters have complied but stocks remain high and prices weak. What now?

It wasn't for lack of trying. Compliance with the supply deal struck last November, at least within Opec, has been high. The diplomacy even to get an agreement between members that are avowed geopolitical rivals, let alone corral Russia into the pact, was an achievement in itself.

But the market's judgement is in—and the deal as it stands is failing, by pretty much every measure one can apply. Saudi oil minister Khalid al-Falih said the cuts would deplete the excess of OECD-held stocks that hangs over the market, eroding the surplus in the five-year average. This hasn't happened and it seems increasingly less likely to before the extension agreed in May expires at the end of the first quarter of 2018.

Benchmark oil prices—Brent was trading at around $46 a barrel at press time and WTI was just above $44/b—have fallen steeply since the end of May, when Opec announced the extension: the opposite outcome expected by the cutters. In the first quarter of this year, when prices were higher, they enjoyed a boost in revenue, justification in itself for the cuts. But that's over. At the oil price and production levels on the eve of last November's deal, Opec collectively earned about $1.5bn a day. At the end of June, the figure was $1.35bn (see graph). Members that were already sceptical of the strategy in private—like Qatar—will only become more doubtful.

An unexpected demand surge isn't going to spring to the rescue. The models for consumption through this year assume 1.3m barrels a day of growth. Not bad—if it bears out. Yet after the weak first quarter, when demand rose by just 0.9m b/d compared with Q1 2016, a big jump is necessary in the second half of the year for the numbers to match up. Even if they do, it's safe to say the collapse in prices—a 60% drop since mid-2014—has not yielded a comparable rise in consumers' appetite for oil. Demand growth in the OECD (half of the market) remains flat, even with the stimulus of cheaper fuel. Data from India and China, the two emerging-market stalwarts, are disappointing.

At some point, price weakness becomes self-reinforcing—and ends up not as weakness but simply the new price. As Seth Kleinman, imminently leaving his job as an oil-market analyst for Citi, points out, oil-producing countries themselves are behind much of the demand growth. Falling oil-export revenue will hurt their economies and lessen their oil thirst. Take Saudi Arabia: its economy is expected to expand by just 0.1% this year, says Jadwa, a Saudi bank. The kingdom's oil demand in March was down by 235,000 b/d compared with the same month of 2016, says the International Energy Agency, which expects 2017 as a whole to show a second consecutive year of declining consumption, such is the "severity of the country's macroeconomic woes".

While the cutters have kept their discipline, other producers are making hay, almost heedless of the price drop

While the cutters have kept their discipline, meanwhile, other producers are making hay, almost heedless of the price drop. Since the November agreement, Libya's oil production—exempt from the cuts—has almost doubled, and now stands at 0.94m b/d. On its own, the rise in Libyan supply has accounted for about 35% of the 1.2m b/d removed by Opec. Officials from Libya's National Oil Corporation told Petroleum Economist on 28 June that the 1m-b/d target for this summer remains intact. That will mark a near-quintupling of supply since last August. Nigeria, another Opec member without a quota, is also coming back. Its production last year struggled to crest 1.6m b/d but should reach around 1.8m b/d with the return of the Forcados export stream. The government predicts even more supply than that.

Don't be mistaken—Opec didn't think either countries' output would rise so quickly. But that miscalculation is nothing compared to its under-estimation of US oil. Until May, Opec's secretariat was predicting supply growth of just 340,000 b/d from the American tight oil patch in 2017. It has since revised up that forecast, though its estimate of 0.614m b/d remains well beneath many other analysts' predictions. Between May and the start of the year—when Opec's deal started—US crude oil supply has risen by 350,000 b/d. Thanks to the price boost Opec engineered in the first quarter, the rig count has soared, and so have drilled-but-uncompleted (DUC) wells: essentially another underground reserve of oil to hit the market when, and if, prices tick up. The DUCs are a rally-killer.

Expect even bigger output numbers from the US over the next few months too. The Energy Information Administration predicts production of all liquids will end the year at almost 15m b/d, or annualised growth of almost 1.7m b/d. On its own, that cancels out the rise in global demand. Despite the recent drop in the oil price, oil consultant Alexandre Andlauer, who has spent recent weeks surveying activity in Texas's Permian Basin, says he expects 150,000 b/d of growth per month from American tight oil is sustainable until end-2017 at current prices. He says 30 frack crews are now on their way to the Permian.

What can Opec do?

Opec and its non-Opec partners will meet in Moscow to talk about all this at the end of July, after we go to press. It won't be an easy meeting, because none of the options are easy.

In terms of pure market balances, deeper cuts would be an answer. To clear the OECD stock overhang—it stood at 292m barrels above the five-year average in April—in the fourth quarter of 2017 would imply a supply deficit of more than 2m b/d. To clear it by the end of the first quarter of 2018 needs a withdrawal of around 0.94m b/d. That's the viable target Opec has in mind, and its cuts should do the job—but not if suppliers outside the group keep ratcheting up their production. Throw Libya, Nigeria, and tight oil into Opec's calculator and the sum of their supply growth wipes out almost all of the cuts.

But deeper cuts to match these numbers would be fiendishly difficult, for several reasons. First, the shuttle diplomacy involved in the Algiers deal last September took months—its own small contributor to jet-fuel demand. To satisfy Saudi Arabia, erecting another agreement now would need, first, the agreement of Russia—but having cut once and now seen its oil revenue start to fall again its ambivalence will only increase. Iran's agreement would be necessary too. Oil minister Bijan Namdar Zangeneh has already said any new deal would be "difficult". For Tehran, 2017 was an ideal time for Opec to rein in supply, because after swift post-sanctions output growth Iran hit a short-term ceiling. But now it is moving ahead again with upstream plans. Iraq, which was hardly a convinced cutter in the first place, also wants to keep increasing capacity—it needs the cash flow. So do Libya and Nigeria: they can't be immediately brought back into the quota fold.

1.7m b/d - EIA forecast for US liquids supply growth end-2016 to end-2017

Goodwill between members is also evaporating—right at Opec's core, among the members from the Gulf Cooperation Council, where the deepening spat between Saudi Arabia and Qatar has demolished notions of Gulf Arab unity. Qatar is too small a producer on its own to wreck any deal in physical terms. But Riyadh's demand for political capitulation from its neighbour could do real damage to its leadership of Opec, especially if the dispute feeds into even deeper regional rivalries.

Above all, though, deeper cuts might simply fail. If removing more oil or—before the physical reality hit the market—talking of removing more oil simply buoyed prices, American producers would drill more wells and produce more oil, snuffing out a rally. It's the outcome that followed Saudi Arabia's cycle of deeper cuts in the early 1980s, and the bruising experience hangs like a spectre over the kingdom's oil policy-making today.

Another option is to end the deal. This isn't being talked about in Opec, although the agreement will end at some point, ideally with a soft landing. And the advocates still point out that although the cuts haven't much lifted income, they have prevented a collapse in benchmarks. The potential for the price to slump when the deal ended in disorderly fashion is terrifying for members.

Still, it's not so far-fetched to imagine the seams coming undone soon. Saudi policy, now unquestionably in the hands of its newly elevated crown prince, is less predictable than before. What happens if Mohammed bin Salman decides the current strategy has failed? If his behaviour in power so far is anything to go by, he's not scared of making sudden changes of direction.

The deal's death wouldn't necessarily come with an official announcement from Opec, either. The first signs of faltering compliance from one of the big producers would do the job. Venezuela, Algeria and other producers that can't raise their production would bleat loudest. The rest would return to their maximalist position of a year ago. It would be a free-for-all again and Russia and Saudi Arabia would lead the charge. The price collapse would hurt, but putting the US rig count into reverse would start to restore some market share—compensation of a kind, but not if oil was selling for $30/b.

Likeliest is that Opec will sit on its hands, postponing any policy shift and hoping for the best. Events tend to be as decisive for oil-price direction as policy set in Vienna, and the ever-rising geopolitical temperature is bullish. More softness in oil prices makes another political eruption elsewhere more, not less, plausible. The fiscal collapse of Venezuela or Nigeria would be enough to change market sentiment. The Qatar-Saudi argument has barely moved the oil price, but if it points to an escalation of Saudi-Iranian enmity in the Gulf the market will at some point awaken to the threat. All the tight oil in Texas wouldn't compensate for a conflict in the Mideast Gulf.

None of that will be mentioned when Opec's compliance-monitoring committee meets in late July. The press conference afterwards will more likely reiterate Opec's conviction that fundamentals are improving, the cuts are working and the group is sticking with Plan A. Doubtless, the private briefings will do their best—once again—to reiterate Saudi Arabia's willingness, in Falih's words, to "do whatever it takes".

A main problem for Opec is that the market no longer believes it will or can do whatever it takes. Hedge funds have bailed on their long positions and traders have tired of the jawboning. As things stand, unless stocks really start to drop in the third quarter, then 2018—when Opec's deal will end—will be awash in oil again.

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