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Back in business, probably

Opec will try to restore some control over oil markets in 2017. Quite how remains uncertain

Opec's informal get-together in Algiers in September proved a turning point. There is now consensus within the group on the desire for stable, higher oil prices - if not agreement on the means of achieving them. Opec's main task in 2017 is to restore the mechanism that has delivered oil-supply constraints in the past to full working order.

That won't be easy. Few within the group welcome the return of individual production quotas. But, whether that unpopular nomenclature or another form of words is used, producers will have to adhere to some kind of national limit if a deal is to stand any chance of working. Market credibility must now be the priority. Any fudge that establishes a new collective production ceiling but glosses over the nitty gritty of how to achieve it would be met with disappointment.

The historical problems of brinksmanship in compliance and incomplete or misleading data will be pressure points in 2017. Even if Opec navigates these various stumbling blocks successfully, a new wave of investment in the US shale patch could undo all its good work.

In Algiers, led by dominant producer Saudi Arabia, Opec consigned its hands-off approach to oil supply - the experiment with organic rebalancing - to history. The organisation was unable to finalise a fully fledged output deal. But it did at least agree to negotiate a bigger agreement - no mean feat after two years of inaction.

The challenge in 2017 will be overcoming internal divisions. Iran, for one, appears reluctant to join a pact aimed at stabilising the oil price in a higher price range if that involves restrictions on the growth of its oil industry. Saudi officials have attempted to head off such disagreements. In the run up to Opec's November 2016 meeting, the kingdom indicated that Iran, Libya and Nigeria would be accorded some kind of special status, given the loss of output they suffered in recent years.

Other producers will argue their own case for special treatment. Iraq, not subject to quotas since the collapse of its oil industry after the first Gulf War in 1990, has questioned the accuracy of the production data Opec uses and says specialist oil media habitually underestimate its production. Iran and Venezuela, in the past two to three decades, regularly made similar claims.

But, without reliable official data from the producers themselves, the market has no choice but to sift through secondary-source information. Facing oil-supply constraints for the first time in decades, Iraq has launched an information campaign to try to persuade analysts that its data are accurate. As long as oil prices remain low, other producers will do the same. On their own, most Opec countries say they want the group to engineer higher oil prices. But they often need to be dragged to the table when it means they cut themselves.

While Iraq has overcome considerable internal difficulties to rebuild its oil production and exports, chronic regional unrest has upset production in Libya and Nigeria. Possible supply recoveries in both countries complicates the arithmetic of who should cut and by how much. Libya is on the way back. Since General Khalifa Hafter's takeover of the oil ports in September, production has risen by 200,000 b/d and further gains will occur in 2017 as eastern oil production is restored. In Nigeria, President Muhammadu Buhari's carrot-and-stick approach to unrest in the prolific Delta region seems to be working. Despite sporadic violent flare-ups, Nigerian production is on the rise and insiders believe it could be back above 2m b/d by early 2017.

The return of these barrels will demand a greater collective effort from other Opec producers if balance is to be restored to the market next year. Opec itself expects demand for its crude to average 32.5m b/d in 2017, more than 1m b/d below its production level in September. In the first and second quarters, when demand weakens for seasonal reasons, the call on Opec crude will fall to 31.3m b/d and 32m b/d, respectively. So assuming more oil from Libya and Nigeria, Opec might need to cut output by at least 1m b/d for the full year, compared with its production level in August, if it is to have any chance of draining crude stocks. Even an output cut of that size would be insufficient to reduce inventories in the first half of the year, when demand is weaker.

The terms of Iran's participation in an output deal, at the time of writing, remain uncertain. Iran has regularly proclaimed its aim of returning production to levels achieved before the onset of economic sanctions. That implies production above 4m b/d. But it has also argued for a share of Opec production of 11-13%.

In Algiers, having initially stuck to this argument, it appeared to consider a compromise and the possibility of a lower limit. But it could easily block any deal and the bar to compromise remains high.

Saudi Arabia's change in tack was forced by the deepening deficit in public finances. But its new supply policy is risky, given the prospect of a resurgence of American liquids production. US shale producers have cut costs successfully and, as soon as oil prices show sustained signs of recovery, much private capital is ready to back the survivors, made hardier by the downturn.

Doubts also hang over projections for global oil demand - a worry Opec doesn't like to acknowledge in public. Since 2008, consumption growth has generally been weaker than it was before the financial crisis that started in that year.

It remains healthy in emerging markets, especially the Gulf, but lower oil prices haven't done much to restore demand in industrialised economies. Use of non-conventional energy in transport remains limited, but environmental policies could spur penetration by hybrid and electric vehicles, chipping away at the demand curve over the coming decade.

Opec is still convinced oil demand will rise steadily, ignoring threats like electric vehicles or new environmental rules. Certainly, it has some reason to be relaxed. Opec's oil is the cheapest in the world. So if global oil needs were to shrink, its producers would maximise their market share.

But Opec's decision to return to supply management reveals its Achilles heel. Its members' failure to diversify economically has left many heavily reliant on oil revenue to finance bloated public-sector spending. While American shale producers have mostly adapted to lower prices, the signs that Gulf economies are prepared for a prolonged period of low oil prices are scant.

So 2017 is a critical year for Opec. The immediate task is to cajole its members into a deal that tightens balances enough to draw down historically high oil inventories and boost prices sufficiently to steady their precarious public finances. That may come in late November 2016 - a decision that would reach physical markets in early 2017.

But Opec's members must also seize the opportunity to make progress on diversification and economic reform now. Scarcity of resource is no longer a limiting factor in global oil and gas - only the cost of recovery is. We should find out in 2017 how efficient Opec's competitors have become and quite how much work the group needs to do to reestablish itself at the heart of the world's oil market.

This article is part of Outlook 2017, our annual book looking at energy market trends for the year ahead. To purchase a copy, click here

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