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As good as it gets for Opec

Compliance with the Opec deal is defying the group's sceptics. How long can it last?

Opec's supply deal is off to a flyer. Compliance among the members that agreed to cut production is more than 90%. Brent, trading above $55 a barrel in mid-February, is about 14% above its price just before the group's meeting at the end of November 2016.

But keep the champagne on ice. January's level of compliance will probably be the high-water mark of this Opec agreement. Discipline fades over time. The more successful the cuts are in raising the price, the greater the temptation for members to cheat their quotas. And the biggest producers stand ready to react when the deal unravels.

Compliance is uneven. Saudi Arabia has slashed almost 0.5m barrels a day, according to Opec's secondary sources (and more than 0.7m b/d according to the kingdom), so is shouldering not just the bulk of the cuts but more than it agreed to, masking other laggards. This will eventually test Riyadh's patience. Data from Iraq and Iran remain unreliable and are unlikely to improve. Both countries like higher oil prices. But their hearts were not in the deal. Iran added 50,000 b/d in January, but remains shy of the raised ceiling it agreed as part of its de facto exemption from the deal. Iraq has cut sharply since December-but remains 125,000 b/d above its agreed target.

As for Russia and the other non-Opec producers that also signed up to cut, reality has not matched the rhetoric. Of the 0.558m b/d they pledged to remove, only half has gone. Russian output fell by 120,000 b/d in January, according to Opec. But some of the barrels removed will probably return as winter begins to lift in Siberia. Kazakhstan's Kashagan field will ramp up later this year, rendering obsolete the 20,000-b/d reduction its oil minister pledged (and described as "symbolic"). Sudan and South Sudan, Equatorial Guinea, Brunei and the others corralled in to bulk up the non-Opec effort aren't going to make up the difference, if they cut at all.

Aside from Opec's Arab Gulf states, which removed 0.82m b/d of supply between December and January, or about 75% of the group total, the only truly bankable cuts—ones that will last the course—come from producers that were shedding supply regardless. Mexico's production will fall in line with the organic loss it predicted before signing the December deal with Opec in Vienna. Venezuela's production dropped again by 30,000 b/d in January; involuntary losses that follow 2016's involuntary 208,000-b/d plunge. Neither country could start raising supply again quickly, even if it wanted to.

A big political shock could render all this, including the Opec deal itself, irrelevant, and the chances of that have risen since 20 January. Donald Trump's chaotic first few weeks as US president have upended geopolitical assumptions, the most basic being that risk does not emanate from the Oval Office itself. Now it does, and it ranges from the macroeconomic consequences of a deterioration in global trade to more war in the Middle East to another regime change in Washington itself. Trump's supporters might discount all this, but risk-sensitive investors on Wall Street and elsewhere are already building scenarios.

Assuming oil prices continue to trade off the Opec deal, though, and 90% compliance is as good as it will get, then $55/b might be about the best to hope for too. And that price is hardly transformative for Opec's economies. Production of 33.9m b/d in October 2016, the full month before the November deal, earned the group gross revenue of $1.6bn a day at the prevailing Opec basket price. At January's average price, after the cuts, the comparable figure was $1.7bn. That's a mild improvement in income, unless you compare it with Opec's revenue in November 2014, on the eve of its fateful decision to let the market slump. Then, earnings on output of 30.4m b/d were $2.3bn a day.

The modest rise in group-wide earnings is not the lifeline that some producers need. Venezuela, the most economically straitened Opec member, marches only a bit more slowly towards the abyss, its debts and public misery increasing daily.

Tight oil rebound

But one producer-region that can feel flush at $55/b is American tight oil. The rise in the rig count since the end of November has been startling—a jump of 25%, to 741 by the week beginning 10 February. In all but one of the seven big US shale regions, oil-production per rig has risen in the past year, so the increase in drilling activity means much more oil.

Opec seems not to believe this kind of data. Its most recent monthly market report forecast that US supply in 2017 would be just 240,000 b/d higher than last year. But its view, telling as it is for Opec's mindset, is beneath the consensus. The International Energy Agency (IEA) expects year-on-year growth of 320,000 b/d. Others forecast a much swifter recovery.

Yet, for the politics of the Opec deal, it is not the year-on-year numbers that are the key benchmark. For Opec and its deal's success, what matters is how much more supply will be added during the period of its cuts, from January 2017 on.

And these numbers are more startling. Total US supply of crude oil and liquids was 13.4m b/d in December 2016, according to the country's Energy Information Administration, but will reach 13.8m b/d by June and 14.4m b/d by December 2017. In the unlikely event that Opec sustains its 90% compliance rate until June, American producers would replace almost 40% of the oil Opec had removed. If the deal is extended through the year, US producers will replace almost every barrel Opec doesn't produce.

For the group's cutters, the good news is that Libya and Nigeria look less likely to destroy their efforts. Libyan's plan to lift output, from 0.7m b/d to 1.2m b/d this year, is laden with political risk—another production drop, if conflict returns to the Sirte Basin, is as plausible as more output growth. Nigeria's government has made little progress resolving its problems in the Delta. Output of less than 1.6m b/d in January was beneath the the 2016 average. The government's plan to increase production to 2m b/d or so is doubtful.

At least stocks are starting to shrink. The IEA says OECD inventories fell by 0.8m b/d in the fourth quarter of 2016, putting them beneath 3bn barrels for the first time since December 2015. But they're still high. And even if Opec sticks to its record compliance rate, yielding what the IEA calculates will be a stock draw of 0.6m b/d, inventories will remain above long-term averages for the first half of the year. Yet, if history is a judge, Opec won't maintain this degree of compliance. After the December 2008 deal, for example, when Opec pledged to cut 4.2m b/d from supply, its compliance hit a high point of 83% but by the following autumn was down to around 58%.

In terms of price, the deal's success also hinges on how much the cutters keep exporting. Evidence that the cuts in production are translating into cuts in supply is thin. With some chutzpah, several producers—from Venezuela to Iran to Iraq—have announced export-growth plans even while they claim adherence to their production quotas.

Export line in the sand

Even Saudi Arabia, so keen to see this deal work that it has gone beyond its quota, is thought to have a red line for exports: these will not go beneath 7m b/d, meaning any shortfall can be made up from storage. An assessment by Genscape, a consultancy with expertise of oil shipping, of tanker flows from the Middle East Gulf shows that "more crude left the … region in January than in any month in 2016". This involved an 8% month-on-month leap from December alone, wrote Genscape's oil shipping analyst Matthew Wheatley. Few analysts of Russia's oil sector expect Russian exports—products or crude oil—to fall, whatever the production numbers. If producers draw on storage to maintain sales, while reducing production, they will eventually drain their own stocks—but not in the time frame envisaged by Opec's current deal.

That points to the bigger question facing Opec as its end-May meeting nears: does it prolong the deal? Venezuela and others that can't lift production (or will keep shedding it) will press for an extension. Indeed, Caracas has already despatched its new energy minister, Nelson Martinez, to make the rounds of Opec capitals. It would also be convenient for Mexico and others, like Azerbaijan, to keep dressing up their organic declines as part of wider efforts to shore up prices.

But Saudi Arabia and its Gulf neighbours have bigger fish to fry. The Aramco IPO, scheduled for 2018, hangs over Riyadh's planning. But the kingdom hasn't yet clearly established whether it thinks production restraint (and higher spare capacity) that helps keep Brent pinned at around $55/b will make Aramco's stock more attractive, or whether it should resume a maximalist output strategy in pursuit of market share and cash flow.

Kuwait and the UAE, meanwhile, are still pursuing their own plans to increase production capacity. The expense is hard to justify if the barrels will not be sold. Qatar, less exposed to Brent because of its rich seam of gas (liquids and liquefied) exports, remains a public proponent of the cuts but privately sceptical of their necessity.

Spend any time with senior Gulf strategists and their worries about the future of oil demand are plain. The prospect of electric vehicles, new conservation efforts, climate-change policy, the penetration of natural gas into the transport segment, and the overarching fear of shale supplies are themes that now punctuate any discussion in the Gulf.

The mood was explicit in Saudi crown prince Mohammed bin Salman's pronouncements last year about freeing his kingdom from its addiction to oil revenue—and visible in everything from Riyadh's recent interest in building new renewable-energy capacity to investing in Uber to the curbing of wasteful energy subsidies.

This gloomy chatter in the Gulf is significant not because these strategists have privileged insight into oil-demand trends, but because of what it says about their production policies now. If, as many senior figures in the Arab Gulf now discuss openly, the world is not going to need their oil indefinitely, what's the point in keeping it in the ground—especially if others won't do the same?

That backdrop is important to this Opec deal and its longevity. If the cutters begin to think the agreement is not bringing the rewards they wanted—or that it is simply restoring the fortunes of rival producers—the unravelling could be swift, the rise in supply startling and the price impact brutal.

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