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Draining the swamp

The oil glut will linger, despite Opec's best efforts

Price stability, at a higher level, is what the cuts are designed to achieve. But to bring that about Opec needs to drain a glut of crude that has built up over the past few years. Khalid al-Falih, Saudi Arabia's oil minister, says he thinks the market will be balanced by mid-2017. Others aren't so sure.

It certainly looks like it will take longer than half a year to tame the raging overhang. If so, whatever Falih says, Opec will probably need to extend its deal in May for the rest of 2017.

"Riyadh knows that running down the overhang will take longer than six months, and one year is widely seen as the time needed to rebalance the market," wrote Amrita Sen, head of consultancy Energy Aspects, in a recent note. "Moreover, stock draws will also push the curve into backwardation-although not until late this year given the size of the overhang-which will deter producers, particularly those in the US, from hedging further forward, a positive for Opec members."

The pace of any draw will depend on whether producers implement their cuts as promised, as well as the level of oil demand over the coming months. Neither is easy to forecast. But the International Energy Agency (IEA) says OECD stocks presently stand at 3.033bn barrels, or 311m barrels above their five-year average-so Opec certainly has its work cut out.

The agreement calls for Opec members to reduce production by 1.16m barrels a day over the first half of 2017, bringing output down to 32.5m b/d. Non-Opec members, including Russia, Mexico and Azerbaijan, have pledged a further 0.558m b/d of cuts, bringing the total to around 1.8m b/d.

Aside from watching how many of these barrels of oil aren't produced, the market will be keenly focused on Libya and Nigeria-both exempt from the cuts, but capable of adding much more output in the coming months. Also, the cut deal is for production, not exports. Some countries, like Russia, may keep their supply to the market robust, even while wellhead extraction falls.

The IEA said in December that if Opec "promptly and fully" stuck to its production target and non-Opec delivered as pledged, the market would move into deficit in the first half of 2017. In January, it said the Opec deal-if complied with-would imply a draw of 0.7m b/d.

In mid-January, Opec's secretary-general, Mohammad Barkindo, said he expected global oil inventories to fall by the second quarter of this year in response to the cuts.

But one thorny issue is identifying how big the supply overhang actually is. Despite the bold predictions, no one could truthfully claim to know the precise figure. While data on oil storage from the US, Japan and Europe are fairly transparent, pinning down stored volumes in other areas can be more problematic. Separating out crude oil and products stocks is also tricky.

Alan Gelder, an oil-markets analyst at consultancy Wood Mackenzie, expects the overhang will still be in place by the year's end. That's based on the assumption that the agreement lasts only for six months and Opec countries muster cuts of around 1m b/d (compliance of about 80%), while Russia cuts around 200,000 b/d, or two-thirds of its pledge. This would pull 100m barrels from inventories by end-2017, he says. It would be enough to support an oil price of $60 a barrel. A 100% compliance would end the overhang in the second half of the year and push prices to $70/b-at which point US tight oil supply would surge.

Sen believes compliance of around 80% is feasible. Gulf Cooperation Council states, accounting for 0.8m b/d of the cuts, can be counted on to deliver. Iraq, on the hook for 210,000 b/d of cuts, is less certain. Few observers expect it to stick to its pledge-not least because the government in Baghdad cannot control exports from the Kurdish-controlled north. Alongside potential growth from Nigeria and Libya, such slippage would slow the glut's clearing.

On the other hand, Saudi Arabia has hinted that it may cut deeper than the 486,000 b/d it agreed to. Angola claims already to have fully complied with its 78,000 b/d reduction (but also has plans to increase capacity). Crisis-hit Venezuela may end up involuntarily losing much more supply than it agreed to remove.

Opec's own market outlook foresees a much swifter draining of the swamp. It calculates that non-Opec supply fell by 0.71m b/d, to 57.14m b/d, in 2016 and expects just 120,000 b/d of growth in 2017. That's a crucial number, because unlike Opec producers now scrambling to live up to their deal, non-Opec producers-especially smaller tight oil ones-are under pressure from banks and other lenders to keep cash flow ticking along. Many of them have been able to hedge prices, thanks to the rally following the Opec deal. So it's possible Opec is underestimating how much supply they'll add in the coming months.

That's the group's main dilemma. It wants higher oil prices-and so needs the market to start pulling crude from global stockpiles. But, in doing its best to make this happen, Opec risks pushing prices to a level that will revive other suppliers, dampen demand growth and maybe even tempt some of its own members to pump more than they agreed.

This article is part of a report series on Opec. Next article: The UAE is committed, but not enthusiastic

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