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Glut or glory

The Opec-non-Opec deal has brought hopes of a price recovery. But its success is not guaranteed

How long will this Opec-non-Opec deal last?

The will of the market is, for now, behind the deal. If the producers who signed up in December manage to cut almost 1.8m barrels a day of supply, as they pledged, the stock draws now already underway will speed up, supply and demand will balance and a tighter market will sustain a $55-a-barrel ledge.

That's what Khalid al-Falih, Saudi Arabia's oil minister, thinks - and he believes it will happen by mid-year. If so, he says, Opec won't need to extend the deal when it meets at the end of May. "The rebalancing which started slowly in 2016 will have its full impact by the first half."

Opec's own secretariat offers a different view. Thanks to slower output growth from non-Opec producers, demand for Opec's oil will rise in 2017, to 32.1m b/d. Yet even if it cuts each of the 1.16m b/d it promised to - and such a compliance rate is unlikely - Opec output of 32.5m b/d will exceed the call on its oil. All being equal, it would need to lop off more supply to achieve the balance it craves.

The real data on the cuts and their impact won't be available until later in February - but not everything will be equal. As our special report this month on the Opec-non-Opec deal shows, only the Gulf Cooperation Council countries can be expected to carry out their cuts to the full. But others won't. And even in the Gulf, scepticism about the deal is plain.

During a December visit to one of the region's shiny capitals, I asked the boss of one of Opec's and the Middle East's biggest state-owned producers for his view on the deal, then just a few days old. His company would make the cuts, he said, but the policy change was a mistake - Opec should have let the market drift lower. But, I asked, wouldn't that have risked the very political stability of other members, like Venezuela? He shrugged.

His answer is a reminder that despite Opec's November agreement, group unity is fragile, at best. If oil-price weakness brings political dysfunction or even the collapse of a weaker member, it might solve a problem for the others. Even now, as most members start making cuts, their implicit hope is that Libya and Nigeria - both exempt - fail to restore order in their oil sectors. Both offer enough potential supply to ruin Opec's best-laid plans, but only if their politics stabilise. More violence in both countries will help the group achieve its price aims - that's the Realpolitik at Opec's heart.

It's also clear that even among the deal's key brokers, scepticism about its chance of success lingers. This is crucial, because if the cuts don't bring a sustained price recovery, the centre might not hold and the deal could unravel quickly.

This isn't a threat yet, because the news from producers is reassuring the market about their commitment. Saudi Arabia, which promised to cut by 0.486m b/d, or about 40% of the group's total, had reduced supply in December (the deal took effect on 1 January) by 158,000 b/d, to 10.47m. Others are doing their bit too.

The news from the non-Opec signatories may be mixed, but it is not yet bearish. Russian supply fell in January, but because of cold weather, and its big producers look ambivalent about cutting, at best - but it has the first half of the year to come good on its pledge, so judgement must wait. Mexico's 100,000-b/d cuts were already baked into the output decline Pemex announced late last year. So were Azerbaijan's. Oman is making its cuts. Others, like Kazakhstan, will probably ignore the quotas they signed up to. Verifying output from countries like South Sudan (which plans a big net rise in supply) will be tricky. But it hardly matters - the smaller exporters will not make or break the deal and the market doesn't expect their compliance.

What will matter is the response of tight oil; the pace of Chinese and Indian imports and US exports; the impact of Donald Trump, dollar strength and other macro-economic factors on global demand growth; the change - and speed of change - in the world's crude inventory; and the political will of Saudi Arabia to stick with cuts if prices don't respond as Riyadh wishes.

Not too high, not too low

The last of these is the easiest to unpick. Riyadh doesn't want fast price inflation, it wishes for prices to remain around $55-60/b - a level that gives some extra income and price stability but won't, in its view, bring a surge in tight oil production.

That's not a price that will rescue Venezuela, or do much to fix the fiscal problems in several other members, including the kingdom. But it is a price band that could spur much higher tight oil growth than Saudi Arabia or Opec thinks. The secretariat expects US oil production in 2017 to rise by just 80,000 b/d. Falih doubts shale's ability to respond aggressively to firmer prices. "As demand rises, they will go to the more expensive, more difficult, less prolific areas in the shale and they will find that they need higher prices," he said at the World Economic Forum in Davos.

But Opec has consistently misunderstood and underestimated the dynamism of tight oil. The International Energy Agency (IEA) expects total US output, including shale, to rise by 320,000 b/d in 2017. Compared with 2016's average, tight oil supply will increase by 170,000 b/d. But, much more significant, the IEA expects tight oil output between end-2016 and end-2017 to rise by 0.52m b/d. Barclays, a bank, forecasts that lower-48 output will rise by 430,000 b/d in the same time frame. The Permian alone may add that much.

As Justin Jacobs's article shows, the US rig count - steadily creeping higher - is no longer the best gauge of tight oil's response to firming prices, because the productivity of each well is now so much greater than it was before the price crashed. The success of November's supply deal may depend as much, if not more, on Texas as on Opec's fractious cutters.

At least demand looks robust. The IEA forecasts a rise in consumption of 1.3m b/d this year, slightly above the average annual rate this century. China's stock-buying programme does not seem to have halted, as some expected and even Europeans are burning more fuel.

Ultimately, the deal's effectiveness will be judged by global inventories: prices can't stabilise at the level Opec wants unless the stock glut begins to drain. The IEA says OECD stocks in November, the most recent month for which it has complete data, stood at 311m barrels above the five-year average. November showed the fourth month of draws in a row - but the withdrawals were "modest" compared with the earlier additions.

Using November's OECD stock number as a baseline, demand in 2017 must exceed supply by 0.85m b/d to bring inventories back to the five-year average by year-end. That's where the mathematics of the Opec-non-Opec deal matter (see table) - and it's what its success hinges on.

It also depends on Russia fulfilling its pledge to remove 300,000 b/d by year end, and all other non-Opec producers meeting their targets. We doubt they will. Success relies, too, on full compliance by Opec's members - but in the months after the 2008 cuts they delivered just 74%. (Although Venezuela might involuntarily lose more oil than it pledged to cut) Lastly, it demands minimal supply growth from Libya and Nigeria. Yet between them, they hope to add about 1m b/d to supply in 2017.

We'll only know how all this is panning out in the coming months. But the broad outlines of Opec's next dilemma are visible. What if the cuts don't work - that they lift prices enough to spark fast growth in the US, resuscitate some upstream plans, and stabilise the price, but at a level that hardly helps fiscally straightened members?

Saudi Arabia's first response will be an effort to cajole discipline and talk up the market - oil minister Falih's recent comments about not extending the deal were an early sign of this, designed to persuade listeners that the outlook was rosy.

But the trap still awaiting the kingdom is the one it side-stepped in November 2014: a 1980s-style cycle of ever deeper cuts that fail to achieve their price goal but shed market share and subsidise rivals. This spectre is so frightful for Saudi Arabia that it will surely avoid the mistake again. If it doesn't work, this latest Opec deal could be short-lived.

What they promised vs what they'll do ('000 b/d)

Country How much to cut 75% compliance PE estimate for compliance  Rating
Algeria 50 37.5 50 Will carry out
Angola 78 58.5 50 Mostly carry out
Ecuador 26 19.5 20 Mostly carry out
Gabon 9 6.75 0 Doubtful
Iran 90 90 40 Will add
Iraq 210 157.5 120 Will partly carry out
Kuwait 131 98.25 130 Will carry out
Libya Exempt Exempt Exempt Could add
Nigeria Exempt Exempt Exempt Could add
Qatar 30 22.5 30 Will carry out
Saudi Arabia 486 364.5 486 May exceed
UAE 139 104.25 139 Will carry out
Venezuela 95 71.25 120  Will exceed
Azerbaijan  35 26.25 35 Expected decline
Bahrain 10 7.5 10 Will carry out
Brunei 4 3 0 Doubtful
Equatorial Guinea 12 9 0 Doubtful
Kazakhstan 20 15 100 Will add
Malaysia 20 15 15 Mostly carry out
Mexico 100 75 110 Expected decline
Oman 45 33.75 45 Will carry out
Russia 300 225 100 Will partly carry out
South Sudan 8 6 20 Will add
Sudan 4 3 Doubtful 
  1812 1359 1460  


Note: Red text indicates additions. Green indicates countries that will shed more supply than they pledged to cut. 

How it might work, how it might not

The Opec deal is only for the first half of 2017, when the IEA expects demand to average 97.05m b/d. That's lower than in Q4 2016, when it reached 97.27m b/d.

So while Opec is cutting, the world will need 220,000 b/d less oil anyway. Opec and non-Opec say they'll remove just under 1.8m b/d from supply in the first half of the year. Combined with lower demand in the first half, that means a deficit of 1.58m b/d.

But supply in December was already 0.5m b/d more than demand. So the deficit to be made up is 1.10m b/d.

The IEA expects 385,000 b/d growth from non-Opec - but over the whole year. Assuming that growth is even, that means additional first-half supply of about 190,000 b/d. So the deficit in the first half would now be about 0.9m b/d.

Stocks are 311m barrels above their average - a measure of the excess. If they made up the deficit, drawing down at 0.9m b/d, they'd end up at about 164m barrels above the five-year average by mid-year.

But all this assumes 100% compliance by the Opec and non-Opec cutters. In 2008, Opec cut - and in the months after, compliance was about 75%. If that level is achieved this time, the 1.8m b/d cuts would become 1.35m b/d cuts. The deficit to be made up in the first half would become 0.63m b/d.

If stocks made up this balance, they'd sit at around 194m barrels above the five-year average at mid-year. The deficit will also be less because some cuts, like Russia's, will only arrive by mid-year. Also, Libya and Nigeria between them hope to add between 0.5m b/d and 1m b/d of supply. If they pulled that off over the first half of the year, stocks may decline only slightly, if at all.

This article is part of a report series on Opec. Next article: Growth hiatus

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