OPEC underpins oil markets into 2018 - green light for tight oil growth

If success is measured in averting another looming supply glut and bolstering OPEC budget deficits, then the nine month extension of production cuts to March 2018 is a triumph of pragmatism.

However, the firmer oil price we expect can only embolden the already resurgent US tight oil industry which is on course to displace the 1 million b/d OPEC has cut within the year.

Three main aspects of the decision stand out

First, an extension is a strong signal to the market that OPEC intends to continue to support price at the expense of market share for the time being. OPEC’s commitment to the production cuts announced in November has been unwavering through April, confounding sceptics. The GCC states, led by Saudi Arabia, actually went beyond compliance; the rest of OPEC and Russia played their part too in the round.

The reward has been a Brent price averaging US$10/bbl higher so far in 2017 than the US$43/bbl in the free-for-all last year. Saudi Arabia alone has benefited by more than US$7bn.

Second, the market proceeds towards rebalancing – albeit like a patient in recovery, at hesitant pace and with a firm helping hand. Our view since January has been that cuts would be extended through end 2017, and that fundamentals tighten. Demand growth exceeds supply growth by around 1.1 million b/d for the year as a whole. A material, sustained draw down in inventory Q2-Q4 rebuilds market confidence and supports Brent at a 2017 average of US$55/bbl.

The returning 1 million b/d from OPEC and 0.3 million b/d from Russia is topped up by another 1.1 million b/d of new non-OPEC production coming from US tight oil, and Brazil and Canada start ups.

Global supply growth exceeds demand growth by 1.1 million b/d, the exact opposite of 2017 and leading to an unwinding of the inventory draw down - back to square one. The extension of production cuts through Q1 begins to address this serious challenge.

Third, the nine month rollover supports prices into 2018. Our analysis ahead of the 25 May OPEC meeting suggested a variation of more than US$20/bbl depending on OPEC’s decision.

Ed Rawle and Ann-Louise Hittle of our Macro Oils team reckoned prices would fall back toward US$40/bbl were production cuts to end in June and plunge the market into the depths of oversupply. At the other extreme, prolonging cuts through to end-2018 could lead to Brent averaging US$63/bbl next year.

In the event, the outcome is middle of the road: easing for OPEC in 2018 the issue of perilous oversupply. The implied stock build in Q1 will be around half that in our prior Base Case.

The extension of cuts into Q1 implies a wait-and-see approach by OPEC led by Saudi Arabia and the GCC group; and that ‘turning the taps back on’ in April 2018 will not be central to the plan. A Saudi Aramco IPO is also on the agenda next year.

All good for OPEC?

Up to a point. OPEC can breathe more easily having averted a potential ‘car crash’ in 2018. Oil prices several dollars higher than they might otherwise have been will bolster severely stretched fiscal positions over the next few quarters.

And prices will not be so high as to trigger investment in new conventional projects – at a very low ebb since 2014. Operators still have their work cut out to get costs down and justify committing new investment in most pre-FID projects below US$60/bbl. Deep water in particular is commercially difficult.

In sharp contrast, US tight oil operators now have added security to invest in short cycle growth.

The rise in the L48 rig count underway for a year already has barely missed a beat these last few months despite price uncertainty. Now the following wind is only likely to strengthen into 2018; yet more rigs will be deployed in the Permian and other key basins.

We have tight oil production growing 1 million b/d by end 2018 in our forecasts – exactly what OPEC itself is keeping off the market. These forecasts are only going one way, tight oil steadily eating OPEC’s lunch.