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Opec ready to stay the course after slow progress

Prices need to fall again if the group's strategy to regain market share is to work

After the doors are shut and the Opec ministers take their seats around the horseshoe table in Vienna's Helferstorfer Strasse on 5 June, their decision should come swiftly: do nothing and keep pumping.

Low prices have brought pain for Opec's producers. The group earned $730billion in net oil export revenues in 2014, down 11% on the year before, says the Energy Information Administration (EIA), and revenue could fall to $380bn this year. The slump has left some members, like Venezuela, perilously close to bankruptcy. It's been a high price to pay for its strategy to recoup market share.

On the surface, though, the plan to let the market drift lower and force higher-cost rival producers offline is starting to work. A year ago, the group's output of 29.9million barrels a day (b/d) met 32.6% of global demand. Now it accounts for 33.7% - a modest improvement, but a start, especially considering violence in Libya and sanctions on Iran continue to restrain the group's potential.

There have been signs, too, of both a cooling in North America's oil sector and a recovery in global demand - exactly the outcomes predicted by Saudi oil minister Ali al-Naimi when he made the case to his peers at last November's Opec meeting that the group should hold firm and let the market alone.

A pull back seems to be underway in the US, where months of falling rig counts are at last starting to slow output growth. Having hit 9.37m b/d in March, production will fall in the coming months to average 9.2m b/d for the year, says the EIA.

A deep retraction in upstream spending across the world's oil industry has been underway, with almost $130bn of planned of investment having been shelved because of the falling oil price, according to consultancy Rystad Energy, cited in the Financial Times. Richmond Energy Partners, another consultancy, reckons drilling activity this year will be 40% lower than last year. That is not good news for long term supply security, but will be music to Naimi's ears.

Opec's plan to regain market share can only work in the long term if its producers are willing to keep output high, and prices low

The demand picture will also reassure the Saudi oil minister. The International Energy Agency (IEA) says demand this year will be 1.1m b/d higher than last year - a sharp rise on 2014's tepid growth of 0.7m b/d. But others are even more optimistic. Consultants close to the Saudi oil ministry say it sees 1.4m b/d as a more likely figure. Goldman Sachs predicts the same, with demand growth of 1.5m b/d to come in 2016.

As encouraging as those numbers are for Opec, the devils remain as ever in the details. First, the demand data are sketchy, and may rely in part on recent cooler-than-usual weather in OECD countries. It is hard to believe that six months of relative weakness in the oil price is sufficient to stop secular shifts in consumption that have been underway for a decade, including rising fuel-economy standards.

Changing habits

China's oil buying habits are no longer as reliable as they were, thanks to slower economic growth that is curbing its demand and its opaque stock-building programme. Bernstein, an investment research firm, reckons that between October and March China bought 58m barrels of oil, or 380,000 b/d, to put into storage. On its own, that would account for much of the rise in global oil demand this year. Likewise, the recent draw in US stocks - taken as another signal that low prices had finally curtailed the tight oil surge - must also be put in context. At 482m barrels on 15 May, the level remains almost 100m barrels higher than it was a year earlier and well above the five-year average. At the rate of the most recent weekly draw, it would take almost nine months for stocks to return to their level of May 2014.

At present prices, falling non-Opec supply - it dropped in April by 260,000 b/d and was matched almost barrel for barrel by the rise in Opec crude and NGLs output - is likely to be shortlived too. The price has risen too quickly, believes Citi, a bank, giving relief to higher-cost producers. The US rig count has been declining steeply each week for the past few months, but has started to stabilise: it fell by just six for the week ending 15 May, and now sits at its lowest point since 2009. But anything above $60/b will see some reactivated, predicts Goldman Sachs. Brent was trading at around $66/b on 21 May. The EIA forecasts that US output will begin to rise again starting in September.

Even the big capital recession underway across the oil sector will take time to translate into falling output. Canada is a case in point. Upstream spending in the west of the country, including the oil sands, is forecast to fall by a third this year - but production from the oil sands will rise by up to 0.5m b/d between now and 2017 as projects sanctioned several years back come on line. Meanwhile, falling costs - as new projects are delayed and labour tightness ends - means oil sands developers see $65/b as an adequate level to start planning again, says one Calgary executive. Russian output, near record highs of 10.7m b/d, is proving similarly robust, helped by falling costs (an outcome of the rouble depreciation) and the Russian tax system, which gives relief to producers as the price falls. After years of disappointment, Brazil's upstream is yielding strong growth too. Pre-salt output has risen to a new high of 0.8m b/d and should rise further as new platforms ramp up.

All of this leaves the market oversupplied by as much as 2m b/d - a balance that does not justify $65/b Brent, which looks overbought. In the past, Opec could have been expected to deal with this, curbing supply to end the excess. Far from putting cuts on the agenda for the meeting in Vienna, however, its members look determined to pump as much as they can. Total group production is now 1.4m b/d above where it was this time last year, more than compensating for the rise in demand and despite a downwards revision, by 300,000 b/d to 29.2m b/d, to the call on its crude.

Saudi output leads the way at 10.1m (including exports of 7.9m b/d in March, its highest level in almost 10 years). Some consultants say it may go even higher, tapping into its 2.5m b/d of spare capacity. Iraqi production is rising and added 0.5m b/d between February and April, when it reached 3.8m b/d. Iran's output, even before any lifting of sanctions, is growing too and reached 2.88m b/d in April, its highest level since 2012. Of the group's members, only Algeria, Angola and Ecuador were unable to lift output in April.

Strategic planning

Some Opec watchers think this rush to pump higher - included plans by Venezuela to increase output by 500,000 b/d in the next two years - is part of the positioning that inevitably precedes a cut, as members seek to establish high baselines from which to withdraw output. Certainly, recent Saudi output numbers send a signal to its rival Iran ahead of any sharp rise in its production next year, should sanctions be lifted.

But the strategy may be plainer than that. Opec's plan to regain market share can only work in the long term if its producers are willing to keep output high, and prices low. Whatever volume of oil is lost from non-Opec suppliers must now be met by an equivalent rise in supply from Opec - if not, the price will rise and tell tight oil and other producers to get busy again.

That's why it is "premature" to say Opec has won its battle for market share, the IEA said in its most recent market commentary. "The battle, rather, has just started". To win, Opec cannot abide prices remaining at $65/b, where they will only encourage a revival in a US unconventional sector that is cutting costs, getting leaner and growing more resilient. At present price levels, predicts Citi, US oil output could "return sooner than expected", while "extremely high stocks, rising US rig counts in 2H15, a likely compression in margins and autumn refinery maintenance point to a potentially bearish end to the year". In other words, Opec must snuff out the latest market rally, pushing prices back down into the hurt zone. Anything less and the previous months' work will be undone, and the pain of falling income will have been for naught.

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