Argus Fundamentals, June 2017

Catch-22

Higher non-Opec supply is already eroding the benefits of the output reduction deal

Eliminating the crude supply surplus looks like an impossible goal. Oil markets are sceptical, reacting negatively to the widely anticipated decision by Opec and its non-Opec allies to extend production cuts to March 2018. Atlantic basin benchmark North Sea Dated fell by $1/bl after the 25 May announcement. Oil prices subsequently slipped to six-month lows of less than $50/bl, and the year-ahead Ice Brent futures contango - prompt discounts to forward deliveries - widened to around $2/bl, indicating an oversupplied market (see graph).

It is too early to determine the impact of the agreement by 24 Opec and non-Opec countries to prolong collective production cuts of just over 1.7mn b/d, Saudi Arabian oil minister Khalid al-Falih says. "We need to stay the course for the full nine months," he says. "We can reap the benefits." Opec wants to reduce a persistent inventory surplus that is depressing oil prices, setting itself a target of returning stocks to their five-year average range.

Hard arithmetic

But the arithmetic of supply and demand is less convincing. OECD industry stocks were 292mn bl above the five-year average at the end of April, the IEA says. A continuous draw of almost 900,000 b/d would be required to eliminate this by 31 March. Argus expects the call on Opec crude to average 32.2mn b/d in the second half of this year - close to last month's Opec output and implying little change in stocks by the end of December. Other analysts are more optimistic, but few expect Opec to be able to achieve its objective by March.

The group's main challenge is rapidly rising non-Opec supply, which is already eroding the benefits of the output reduction deal. Argus expects non-Opec production to rise by 1mn b/d this year. Non-Opec output increased by just over 600,000 b/d on the year in January-May, after falling by 670,000 b/d in 2016. And non-Opec growth is forecast to accelerate in the remainder of this year, as US production rebounds. Government agency the EIA now projects US crude and condensate output to climb by 1mn b/d in the 12 months to December.

"Tight oil lived up to its billing," BP chief economist Spencer Dale says. "It responded far more quickly to price changes than global conventional oil and, as such, dampened price volatility on the downside and, more recently, the upside." And Dale cautions against underestimating its resilience. "Trying to kill off tight oil makes no sense," he says. "Tight oil is not the marginal barrel in the longer run - other sources of supply have higher all-in costs. As the market adjusts and prices recover, it will spring back, exactly as we are seeing."

Opec accepts this. "Shale producers are a phenomenon that we have to understand and we have to co-exist with," al-Falih says. "This is a big market, and growing... and conventional legacy oil is declining," he says. "We need new supply sources to replace the decline and meet incremental demand. Unconventional oil and shale is going to play a key part, and we need it to play it."

But there is a catch. Breakeven costs for new non-Opec capacity are falling. A typical rig in Texas' Permian basin produces nearly three times as much oil as it did at the end of 2014. Independent EOG Resources now requires an average price of $47/bl to fund capital expenditure and pay dividends from cash flow, down from $50/bl at the start of this year. And the average breakeven price for a new stand-alone project in the US Gulf of Mexico has dropped to $40-50/bl from more than $70/bl in 2014, consultancy McKinsey says.

Higher oil prices will encourage more non-Opec supply if Opec makes deeper output reductions. But if Opec boosts production, oil prices and the group's revenues will collapse. Like Joseph Heller's fictional pilot, Yossarian, Opec hopes to evade Catch-22.

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