There has been much optimism since last week on the possibility of extending the current production-cuts agreement between the Organization of the Petroleum Exporting Countries (OPEC) and its allies beyond its expiry next March.
The optimism was fueled by the recent comments of Saudi Crown Prince Mohammed bin Salman, who said on Oct. 26 that his country was ready to extend the agreement.
There is another reason that might further fuel the speculation on the extension, and it came from the International Monetary Fund which said on Oct. 31 that Iran, Iraq, Kuwait and Qatar will have budget surpluses in 2018, while Saudi Arabia will need an oil price of $70 to break even its fiscal balances.
The improved outlook for the fiscal situation would be really encouraging for oil producers to maintain market stability and to keep oil prices at around current levels of $60. One of the best ways to do that is to stick to the current agreement, presumably, until the end of next year.
The agreement itself is a driving force for the rebalancing of the oil market that has been lost since mid-2014, and the crown prince acknowledged this in his statement that was released by the newly created Saudi Center of International Communication.
What’s more important is that the crown prince acknowledged that there are challenges. “The journey toward restoring balance to markets, led by the Kingdom, is proving successful despite the challenges,” he said in a statement.
So, what could possibly be the challenges to the journey to rebalancing the oil market?
The first and foremost challenge is the compliance level with the current agreement. Certainly, the market won’t stay stable without higher conformity levels with the cuts.
Banks such as J.P. Morgan, Bank of America and Goldman Sachs all attributed the improvement in prices to higher compliance levels in addition to other major factors such as increase in demand for oil that is supported by high refining margins.
The compliance level for OPEC and non-OPEC producers participating in the agreement was 120 percent as of September. That is the highest since the start of the deal in January and the highest ever in the history of all OPEC deals with non-OPEC producers.
Reaching this level, however, wasn’t an easy task and the crown prince knows more than anyone else how much political effort Saudi Arabia invested in order to see improvements in compliance.
It all started in July days before the Joint Ministerial Monitoring Committee met in St. Petersburg in Russia. Back then Saudi Energy Minister Khalid Al-Falih told other ministers that there was no other way for this deal to go further without better compliance.
Al-Falih then went on to visit some of these countries and through official correspondence and inviting them to OPEC functions such as the meetings of the Joint Technical Committee things started to improve slightly. Some of them, however, made additional cuts by force and not by choice, but at the end the results were good for all.
J.P. Morgan acknowledged the efforts made by Saudi in a report on Oct. 27. “The hallmark of Saudi Arabian leadership is evident in the current agreement, with average compliance for Saudi Arabia above 120 percent for the first three quarters of 2017,” the bank said. “This is substantially better compliance than any of the other major OPEC producers.”
Now, going forward, the compliance challenges will still be there next year. With higher oil prices and the prospect of higher oil demand come higher revenues and that would encourage some producers to raise their production.
Some banks such as J.P. Morgan are already anticipating lower compliance next year. However, a drop in compliance will take time and “if compliance levels were to drop, they likely would drop gradually toward the end of 2018 or when the deal achieves its goal of lowering global oil stockpiles to a five-year average.
Another possible challenge next year is the ability of many oil producers to pump crude at lower levels, which means that more supply can hit the market, even with oil prices staying between $50 and $60.
Big oil companies such as Total are already assuming a break-even price next year or in 2019 at around $20. Even expensive offshore developments are becoming competitive. Petrobras, Brazil’s largest producer, sees break-even of some of its pre-salt projects such as Libra at $33, the CEO of the company said on Oct. 27.
Shale oil producers such as Pioneer are increasing hedging for their production next year and need as low as $20 to break even this year as they keep cutting costs, a trend that would continue next year.
Last but not least of the challenges is the exiting strategy. Agreeing on an extension is straightforward but exiting the deal should be crafted well to avoid disturbing the market balance. The Saudi energy minister said that any exit should be smooth but OPEC has not until now announced any strategy on how to exit from the deal.
With all the current success, OPEC and its allies are in half-time mode now as OPEC’s Secretary-General Mohammed Barkindo said in Kuwait last month. They now need to focus on the second half of the match, and that won’t be easy.
• Wael Mahdi is an energy reporter specializing on OPEC and a co-author of “OPEC in a Shale Oil World: Where to Next?” He can be reached on Twitter @waelmahdi