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OPEC and non-OPEC pact: An endgame becomes necessary

Dr. Mohamed A. Ramady

Published: Updated:

OPEC’s suspense party is over, at least for the next few months as the cartel and its partners, including Russia, agreed to extend oil-production cuts to the end of 2018 and caught the market by surprise by including Libya and Nigeria in the deal for the first time, while leaving Iran uncapped.

This was probably because unlike the wider production fluctuations by the two African countries, Iranian production seems to have stuck at around 3.75 mbpd given Iranian capacity constraints. Libya and Nigeria, previously exempt from cutting production due to internal strife, agreed to a collective cap on their output that exceeds the nations’ current production and in effect means their inclusion won’t immediately deepen the overall level of supply reduction. Still, it is a positive step forward as it reduces the risk of upside surprises to production from those countries.

The latest Vienna OPEC and non OPEC outcome reflects a continuing rare consensus with all agreeing that the market is moving in the right direction, but admitting that it is not yet balanced. OPEC agreed to review the deal at its next meeting in June 2018, but one of the sticking points was whether Russia would agree to a renewal of the new relationship with OPEC or have reservations, especially as to what an end game looks like once prices reach higher levels above $65 ranges with implication to the Russian economy, and to wider demand and supply consideration at such higher price levels.

ALSO READ: OPEC agrees oil cut extension to end of 2018

For the immediate future, extending into at least the first two quarters of 2018, OPEC ministers have very clearly said that they’re extremely committed towards getting that inventory overhang down. According to Saudi Energy Minister Khalid Al Falih, it would be premature to talk about an exit strategy because OPEC and its allies are relying on oil demand in the third quarter of 2018 to finally eliminate the inventory surplus, but at the same time the Kingdom is open to discussions about how the group could wind down the cuts “very gradually” once its goals are achieved. This was the sweetener that Russia wanted to hear.

Russia had previously sought assurances on how and when the agreement would be phased out, and Russian privatised companies like Rosneft and Lukoil needed greater clarity than most OPEC members because Russian economic policy making is more complex, including a floating exchange rate that fluctuates with the oil price compared with the fixed currency peg of major Gulf producers like Saudi Arabia and the UAE. Moscow also wants a schedule of how the cuts will end so it can guide privately owned Russian oil companies and their foreign partners about future output.

Despite the success of the meeting, OPEC was given an immediate sign of the challenges it still faces, especially from a resurgent boom in shale oil production as the US government reported a large increase in domestic production in September, bringing the total to 9.48 million barrels a day, the fourth-highest monthly level since the early 1970s. At $60 plus a barrel, most US shale producers will become profitable and are likely to be seen as more attractive for investors heading into next year, creating a dilemma for OPEC production unity.

However there are some who believe that the shale revolution and its premise of ever increasing technology led advances has been exaggerated and that OPEC and its non OPEC partners could still wield a strong market dominance factor as researchers at MIT have uncovered one potentially game-changing detail: a flaw in the US Energy Department’s official forecast, which may vastly overstate oil and gas production in the years to come.

The studies suggest increases have been largely due to something more obvious: low energy prices, which led drillers to focus on sweet spots where oil and gas are easiest to extract, and that geology is more important in the long run. As fewer and fewer high quality sweet spots are drilled, second and third tier, less productive shale fields will find it harder to take up the burden of increased shale production.

This is indeed sweet music to OPEC ears but in the short term and peering into 2018, the organization and Russia have to start considering how to ease back on their successful cooperation and discipline and start thinking about increasing their market share in face of diminishing world supply, the so called rebalancing, and possible increase in world oil demand.

As fewer and fewer high quality sweet spots are drilled, second and third tier, less productive shale fields will find it harder to take up the burden of increased shale production

Dr. Mohamed Ramady

Exit strategy

For the time being, OPEC ministers did not have a detailed discussion about the mechanism that will be used to review the deal in June. In effect, OPEC-plus seems highly likely to agree to a certain three month extension in the current output cuts agreement from March next year, with the remaining six months dependent on the developments in oil prices.

The current output cuts could be extended for the remaining six months if needed to underpin "stable" oil prices around an equilibrium deemed for now to be around $60. But if prices are rising too high too quickly, the oil ministers will have to start work on a new mechanism or "exit strategy" in which there would be a "reverse tapering" or laddering up of output shared among the 24 participating oil producing countries.

This work on an exit strategy is perhaps the most important new development that could emerge in the months ahead. To avoid the trampling of oil prices if, or when, the OPEC output cuts fall apart against the backdrop of steadily rising prices, the idea is for an equally coordinated “reverse taper” or scaling up of oil output increases over a set period.

ALSO READ: Oil eases as traders, investors grow edgy ahead of OPEC meeting

Much more work will need to be done on how exactly coordinated increases in output would be shared up among participating states. Perhaps just as importantly, borrowing from the forward policy guidance of the US Federal Reserve and the major European central banks, the OPEC leadership will be looking at how best to signal their messaging to sway the trading in the crude futures markets and avoid a sharp downward price spiral that will put their painful road to price stability under pressure.

Once again, Saudi leadership in any future tapering down agreement will be essential for success. A key element for any progress on an OPEC exit strategy will be a Saudi willingness to be “first in/last out” in revised quotas, meaning its increase in oil output would come last behind the small increases by the other oil producers, and perhaps to no higher than 10.2 million bpd, or below its 10.8 million bod baseline at the end of last year.

All the above is also assuming that forecasted future oil demand is going to materialise, when there are indications that the Chinese demand for oil imports could slow down and warning about an economic slowdown in major Western economies, with some characterising the state of the US stock market as one of a “ bubble “ about to burst. When and how to start the tapering down of the current production agreement under changing demand scenarios, becomes even more of a headache.

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Dr. Mohamed Ramady is an energy economist and geo political expert on the GCC and former Professor at King Fahd University of Petroleum and Minerals, Dhahran, Saudi Arabia. His latest book is on ‘Saudi Aramco 2030: Post IPO challenges.’

Disclaimer: Views expressed by writers in this section are their own and do not reflect Al Arabiya English's point-of-view.