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Will the new shale surge wreck the rebalancing?

As tight oil soars, producers should welcome the retreat in prices. Cheaper oil is the best chance to bring back market equilibrium

No one should doubt Opec and its partners' success. They have beaten expectations on compliance with the cuts and on the longevity of their deal. But the goal of the exercise—market balance—is receding again. Not until the end of 2018 will equilibrium be reached, the group says. Given how quickly tight oil supply is rising, and Opec's tendency to underestimate it, even that distant target looks optimistic.

The market is suddenly out of Opec's control again. Opec shows no wish to deepen the cuts, which would only surrender more customers and further spur rival production. Nor can it abandon the cuts to beat back American drillers, as it tried to do in 2014—the price fall was too painful.

Its only option is to keep alive the idea that "cooperation" between Opec and Russia is for the long term and the cuts will go on as long as it takes—shooting down, whenever possible, the persistent rumours that Russia wants out in June. This is critical, because any hint of "Opexit" would crush prices.

But this is a tricky path too. Every time Khalid al-Falih, Saudi energy minister, speaks about the cuts enduring through 2018, he gives more confidence to producers, not least in Texas. The kingdom, it's understood, wants to keep Brent above $60 a barrel—a price that will help both its budget and the valuation of Aramco when its 5% sale is arranged. At the International Energy Forum in Riyadh on 14 February, Falih said that if the Opec-non-Opec cuts ended up overshooting the market, "so be it". Music to all producers' ears.

Whether the market will overshoot in 2018 is, though, increasingly difficult to say. Bulls point to strong demand growth this year: Opec says consumers will need almost 1.6m barrels a day more oil; others, such as S&P Global Platts' Pira Energy Group, say growth will come in at 2m b/d. Bulls also cite the rapid fall in OECD stocks as proof of the market's tightening. The International Energy Agency (IEA) says the inventory plunged by almost 56m barrels in December, "the steepest drop since February 2011", to end 2017 just 52m barrels above the five-year average. A year ago, the overhang was 264m barrels. The glut has almost cleared.

Opec itself thinks more work is needed, reporting the overhang is still 109m barrels, saying "the market is only expected to return to balance towards the end of the year". As Falih suggested in Riyadh, its members would rather err on the side of over-tightening—bringing a price windfall—than risk easing off the cuts too soon.

Shale surge

But the high-water mark for the market's tightening may already have been reached. US tight oil growth is so rapid again and the volumes so great that it's shredding the balances. In February, the US Energy Information Administration (EIA) said American crude output had reached 10.2m b/d. A year earlier, it forecast that output for all of 2018 would only average 9.5m b/d. Between August 2017 and end-January 2018, production rose by 1m b/d. From end-Jan to exit-2018, the EIA expects about another 1m b/d.

Having digested these shocking numbers, Opec revised up its non-Opec growth prediction for 2018 again in February, to 1.4m b/d, 530,000 b/d more than it expected in November, when the group met to roll over its cuts. Even this new number looks low. The EIA expects year-on-year non-Opec growth of 2.35m and the IEA 1.7m. An Opec source concedes the group will likely increase its forecast again in March.

This supply onslaught is exactly the outcome Opec wanted to avoid and didn't think possible. It's a scenario in which its need to protect the good work of the past months—high compliance with cuts, leading to rapid stock draws and rising income on the back of a 20% increase in oil prices since July—means it must keep cutting, even while surging non-Opec supply threatens to undo the achievement.

Every time Khalid al-Falih, Saudi energy-minister, speaks about the cuts enduring through 2018, he gives more confidence to producers, not least in Texas

Not all is lost for the rebalancing effort, because while the non-Opec supply numbers are bearish, other factors aren't. Venezuela's supply losses will accelerate in the coming months, believe many analysts. Its production in January was 1.6m b/d-a year-on-year drop of 400,000 b/d. If that calamity is repeated this year, it would tighten the heavy oil market many Opec exporters trade in and dent the effect of non-Opec output rises.

The macroeconomic backdrop is rosy—demand may surprise on the upside this year. Even IEA officials privately acknowledge that its comparatively low number (1.4m b/d of growth) may need recalibrating. The OECD Americans and Europe both consumed more oil than expected in the second half of 2017, and the economic outlook for all regions is improving for 2018. Chinese demand continues to outperform year-earlier forecasts and may again this year. India's demonetisation blip, which hurt consumption growth last year, has passed.

Crucially, more economic strength in some oil-producing countries is boosting their demand. Opec forecasts stronger consumption growth in the Middle East than last year. A recovery in Russia is significant: so close is the correlation between its economic growth and domestic oil demand that faster GDP expansion should cut into oil volumes available for export.

In short, strong supply growth looks baked in, and will weigh on the market-perhaps delaying again the rebalancing. But demand will now have its say. And on this front, surging output from Texas can do Opec a favour. The group showed no desire to cap the oil-market rally of early 2018. Left unchecked, price inflation would have started to eat into demand-growth projections. Tight oil has done the job instead, softening prices before consumers started to hurt. The market rebalancing effort is getting harder again, but Opec has a better chance with Brent at $60 than at $75.

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