OPEC's production cut is here to stay, at least for now. During a meeting in Vienna on May 25, major oil producers from around the world agreed to extend the measure, adopted in November 2016, for another nine months. The deal was hardly a surprise; many of the oil cartel's key members signaled weeks ago that they supported prolonging the production cut. The main issues at stake were details such as how long to continue it and whether to deepen it by increasing voluntary reductions or including more countries in the deal. By and large, though, the production agreement remained unchanged, and despite the forces working against it, the cut's extension will start restoring balance to the international oil market. Supply will gradually creep back in step with demand. More important, global oil inventories will inch closer to their five-year average levels. But as OPEC, along with major oil producers outside the bloc, get closer to achieving these goals, they will face a different dilemma: how to ease out of the deal.
A Crude Strategy
By the time OPEC and other major oil producers agreed to cut production some six months ago, the measure was years in the making. Saudi Arabia steadfastly resisted curbing production when oil prices started falling in the second half of 2014 (having peaked at $115 per barrel in June of that year). Instead, it did the opposite, boosting production from 9.5 million barrels per day in December 2014 to 10.5 million bpd by mid-2015. Riyadh hoped that by ramping up production it could expedite the decline in oil prices — which may have been inevitable anyway — and drive North American shale oil producers out of business. The strategy worked. Prices dropped precipitously in 2015, before bottoming out at around $26 per barrel in January 2016, and U.S. shale production also started to fall.
But months of flooding the market with oil had yielded another consequence: a massive surplus. Commercial crude oil stockpiles among countries in the Organization for Economic Cooperation and Development (OECD) rose from 994 million barrels in at the end of 2014 to 1.18 billion barrels two years later. Saudi Arabia and the rest of OPEC had to shift their attention from trying to protect their market share by staving off shale producers to rebalancing the global oil supply. The time had finally come to cut production.
So far, though, the measure hasn't had its intended effect. Part of the problem is that oil production has resurged in Libya since the original deal — which slashed 1.5 million bpd in production in the first quarter of this year — was negotiated. In the United States, meanwhile, improvements in technology have lowered production costs, leading to increased production (a trend that will continue so long as oil prices stay close to where they are now, around $50 per barrel). Global stockpiles have kept rising, thanks to seasonal production increases to meet higher demand for oil in the summer and winter. By the end of March, OECD members' stocks of crude had reached about 1.24 billion barrels, up half a million barrels from the previous year. The increase was modest, all things considered. Nevertheless, it demonstrated that the OPEC cut had only slowed the accumulation of excess oil rather than reducing the surplus.
Slowly but surely, that will change, and the move will start to chip away at the world's stores. Oil demand is expected to grow by an average 1.3 million to 1.5 million bpd each year, while production at existing wells will naturally decline. Together, these forces will eventually conspire to diminish oil stockpiles around the world, even if increased production in countries such as the United States cancels out the OPEC and non-OPEC cuts.
Calculating 'Whatever it Takes'
Saudi Arabia's new stated goal is to reduce oil stockpiles to their five-year average levels. In a deliberate attempt to shape market expectations, the kingdom's energy minister has promised to "do whatever it takes" to get there. Extending the production cut is a good start. The oil market has already largely achieved a balance between supply and demand. Over the next year, demand is expected to rise by roughly 475 million barrels in total. Assuming oil production increases by less than 215 million barrels in the coming nine months, Saudi Arabia and its fellow OPEC members will reach their goal by the deal's expiration in March 2018. Even if oil inventories don't return to the five-year average level for last year, they will probably have no trouble meeting the most current levels. The average for March 2018, after all, will be calculated based on the years 2013-2017, when oil stores began rising in earnest. To attain that level, only 185 million barrels of oil will need to be withdrawn from storage, rather than 261 million.
Of course, production in countries outside the deal could jeopardize its progress. Beyond the United States, Nigeria and Libya are the two oil producers that could throw a wrench in Saudi Arabia's plan. Both countries were exempt from the agreement to cap production, and they were excluded from the extension as well. But Libya's oil production has kept surging even since the first quarter of this year. Today, it is churning out about 800,000 bpd, roughly 120,000 bpd more than it was producing in March. And it doesn't plan to stop anytime soon: The country's national oil company has set its sights on reaching 1.2 million bpd in production by the end of the year. It's a lofty goal, but even if Libya's production stays put, it will contribute 40 million barrels of oil through 2018. In Nigeria, likewise, production is on the rise. The country finally got the Forcados crude export terminal up and running again in May after a militant attack in February 2016 took it offline. Now that it's back online, the facility could add another 200,000 bpd or so to Nigeria's crude oil production — putting at least an additional 50 million barrels on the market through the end of the deal.
The Oil Producer's Dilemma
Because of the tenuous security situations in both countries, however, Nigeria and Libya may fall short of these numbers. And regardless, storage levels will still be close to their five-year levels at the end of March 2018. Some of the deal's participants, in fact, are already looking ahead to what comes after the production cap expires. Rosneft CEO Igor Sechin recently called for Russia to negotiate an exit plan to the deal. Considering the extent of the cut, easing out of the agreement without overwhelming the markets will be no small feat. As its end date approaches, moreover, ensuring compliance with the production ceiling will become trickier.
So far, the deal's participants have overwhelmingly adhered to its terms, though as in previous production agreements, not everyone has played by the rules. Compliance among OPEC members has been at least 90 percent for the duration of the cut, and in April a record 66 percent of non-OPEC members were observing the agreement. One factor driving the high compliance rate is that many oil producers understand it's better to go along with the deal than risk undermining it, given that reducing the world's stockpiles will be a lengthy endeavor. Even so, the temptation to cheat the system looms large.
Each member in the agreement has its own degree of commitment to the deal or incentive to go against it. The differences will become all the more apparent as the goal of the production cut comes into view. For countries such as Venezuela, which is scrambling to pay down its foreign debts, the need for revenues in the short term could eclipse concerns over the oil market's viability in the long term. Gabon, similarly, may opt to drop out toward the end of the agreement, when it is less likely to face recrimination for withdrawing and restoring the 9,000 bpd in production that it has sacrificed. By contrast, the countries best poised to withstand reduced production, such as the Gulf Cooperation Council states, will stick it out until they've reached their goal. Saudi Arabia, for example, is determined to revive the global oil market before it puts shares of the Saudi Arabian Oil Co. up for initial public offering.
The diverging priorities among the deal's participants help explain Sechin's insistence on devising an exit strategy. The production agreement has taken 1.6 million bpd off the market — more than a year's worth of demand. To avoid disrupting the global oil market, participating countries will need to resume their production in phases, likely beginning before March 2018. In the meantime, the newly extended production cut will help gradually correct the disparity between supply and demand on the global oil market. Now that the agreement has been finalized, however, the conversation will turn more and more to gaming out the deal's final stages and seeing it through to the end.