Oil prices cascaded to their lowest level in more than three months in mid-March as a confluence of bearish reports heightened market concerns that resurgent shale oil production will undermine OPEC’s strategy to accelerate a drawdown in global oil inventories. The unexpected strong rebound in tight oil production in 2017 is further inflating the plethora of crude stocks in the United States that are already weighing on markets. Emerging tensions among some OPEC and non-OPEC producers over noncompliance with lower production targets and uncertainty if the alliance will extend the agreement to the second half of the year further eroded market confidence.

Oil markets remain on track to rebalance this year but the pace of the recovery is expected to be slower than previously projected given stubbornly high stock levels, according to the latest data from the major forecasting agencies. Echoing other oil experts, the International Energy Agency emphasized that more time was needed for the full impact of the OPEC and non-OPEC cuts to reach global markets. The marginally more bearish March oil market reports from the IEA and the OPEC Secretariat added further uncertainty into increasingly volatile markets.

Market Fatigue

Traders quickly bid oil prices up by a sharp 20 percent after OPEC and some non-OPEC producers agreed in late 2016 to reduce production by almost 1.8 million barrels per day (mb/d) beginning on January 1, 2017 for a six month period. Prices for U.S. West Texas Intermediate (WTI) stabilized in a higher $52-54 per barrel (bbl) range for the first two months of the year but the exuberance that propelled prices to the loftier levels has given way to market fatigue as traders wait for data signaling the much-anticipated drawdown in global oil inventories is underway.

The joint OPEC and non-OPEC production agreement supported WTI futures at a higher average price of $53/bbl between December 2016 and March 7, about 20 percent higher than levels posted the day before OPEC announced its agreement, on November 30, 2016. Just over two months into the deal, however, the market’s confidence is wavering. Crude futures prices reached a breaking point on March 8 after the U.S. Energy Information Administration released weekly data that showed domestic oil inventories rose for nine straight weeks to record levels. Prices tumbled 5 percent that day but continued on a downward trajectory as hedge funds and other money market managers, who had been betting on a steady rise in prices this year, started unwinding their long positions in crude oil futures and options contracts in line with the shifting market sentiment.

The OPEC Secretariat’s latest monthly market report showing Saudi Arabia had increased production to 10 mb/d in February added further downward pressure on prices. Though still within its new quota allotment, the increase in Saudi production sparked concerns that the kingdom was signaling its frustration to other producers who were not meeting their commitments. By March 14 WTI oil prices had lost about $5.50/bbl, closing at $47.72/bbl, which was the lowest level since OPEC announced it would reduce production in November. Futures prices have since edged lower, with WTI trading at $47.35/bbl and international benchmark Brent crude around $51/bbl.

Short-Term Focus Clouds Stronger Outlook

Not for the first time, the market’s myopic short-term focus is casting a dark cloud over what otherwise are constructive data on supply and demand fundamentals, albeit slightly more bearish than February’s reports. A surge in OPEC production in December ahead of the new January 1 lower output targets led to an increase in the stock surplus as supplies moving by sea arrived in consumer markets in the first few months of 2017, according to the IEA’s March 15 report. After slowly declining for the previous five months, commercial oil stocks in the OECD industrialized countries rose by 20.1 million barrels to back above 3 billion barrels in January.

Global oil demand was unchanged from February’s report with growth forecast to rise by 1.4 mb/d to 98 mb/d in 2017. Demand is forecast to overtake supply in the first quarter of 2017 and accelerate throughout the year, according to IEA data. However, while the annual increase is unchanged, the IEA adjusted demand growth on a quarterly basis, reducing it by 400,000 barrels per day (kb/d) in the first half of the year and shifting the increase to the second half. As a result, global inventories are now expected to decline by around 500 kb/d from January to June compared with February’s forecast of 860 kb/d. Assuming OPEC extends its agreement for the full year, oil inventories are forecast to decline by a sharp 1.7 mb/d from July to December compared with the previous estimate of 1.4 mb/d. Based on current estimates, global oil inventories will not decline to the five-year average of 2.7 billion barrels until the last few months of 2017 compared with previous projections of an early third quarter realignment.

Non-OPEC supplies are forecast to increase by 400 kb/d to an average 58.1 mb/d in 2017, up modestly from February’s report, according to the IEA. That compares with a sharp 900 kb/d decline in 2016. The Americas continue to provide the lion’s share of the increase, with higher output from the United States, Brazil, and Canada, while China and Mexico are forecast to post the largest year-on-year declines, according to the IEA. Led by rising tight oil production, total U.S. production is forecast to increase by around 400 kb/d in 2017. The EIA monthly report showed crude production rose for five consecutive months, reaching 9 mb/d in February. Underscoring the growth, the total U.S. oil rig count rose to 617 in early March compared to a low of 318 in May 2016.

History of Revisions to Shale Oil Forecasts

Repeated upward revisions in the outlook for shale supplies for 2017 by the EIA, the primary source of information on U.S. production, has injected a high level of uncertainty in the current forecasts. The industry-changing technology that unleased the rapid rise in shale, or light tight oil, since 2010 continues to evolve, making forecasting exceptionally difficult. The EIA has revised its December 2017 production projection in the lower 48 states, comprised largely of light, tight oil, upward by a significant 1.4 mb/d from March 2016 through March 2017. The EIA explained that revisions are due to higher oil prices that have spurred an increase in the number of rigs drilling as well as improved modeling techniques for forecasting production. Technology advances in development and production of the oil and ongoing improvements in production economics such as increased well recovery rates have consistently defied forecasts, and make forecasting production exceptionally difficult compared to conventional reserves. As a result, modelling the outlook has been problematic.

Market analysts are concerned the EIA is continuing to underestimate the outlook for an increase in shale output in 2017 and 2018, which would further undermine the impact of OPEC’s production cuts. In January, the EIA released its first forecast for 2018 but as of the release of the March monthly estimates, those numbers had already been revised higher by a steep 450 kb/d for December 2018. In January, the EIA forecast that Lower-48 production would rise to 6.98 mb/d by December 2018. Just two months later, the March report predicts an increase to 7.43 mb/d. The EIA is forecasting an annual increase in shale production for 2017 of around 300 kb/d but independent analysts believe output could actually increase by 500-800 kb/d. April production is expected to reach 5 mb/d, the highest level in almost a year, led by strong increases in the prolific southern Permian Basin, according to the EIA. Production in the Permian Basin is forecast to reach a record 2.3 mb/d in April, to just under half of total U.S. tight oil output.

Uneven OPEC Production Compliance

Data issues are not just a problem for shale oil forecasts; estimating monthly OPEC production has been a chronic problem for decades. OPEC compliance with the new accord was assessed between 60 and 90 percent for February with the varying estimates because there is no standard methodology for calculating the metric among international agencies such as OPEC and the IEA, oil industry analysts, and news organizations. The IEA reported OPEC production rose by 170 kb/d to 32 mb/d in February, with compliance easing to 91 percent from an upwardly revised 105 percent in January. Venezuela and Iraq are still producing well above their new quotas. By contrast, the OPEC Secretariat, in its monthly report, which uses an average of secondary sources because there is a credibility issue with data reported directly by its own members, said supplies declined by 140 kb/d to 31.96 mb/d. OPEC also publishes monthly production levels from direct communication with members but can’t provide a total since not all countries report data.

Saudi Arabia reported a much higher production level for February in its direct communication to OPEC than was reported by secondary sources, which sent the market reeling and oil prices even lower. Saudi Arabia is one country that analysts believe reports reliable data to OPEC so the increase in February after a steep cut in January levels sent mixed message to analysts. In January, Saudi Arabia made deep cuts in production to compensate for weak compliance from other countries but in February the kingdom increased output by 265 kb/d to 10 mb/d. Though still below its official quota, the increase was interpreted by some market analysts as evidence that the kingdom was signaling it is prepared to raise output further if other OPEC and non-OPEC countries party to the agreement do not toe the line and meet their obligations. Non-OPEC producers have pledged to reduce production by 558 kb/d but data for February shows the 11 countries only reduced production by just under 200 kb/d for an estimated 40 percent compliance level, according to the IEA.

Managing Market Expectations

For OPEC, perhaps the biggest challenge to rebalancing oversupply and supporting stronger prices is managing market expectations. The record level of commercial oil stocks in the OECD countries built up over two and half years, and it will take at least six to nine months to contract. The annual CERAWeek gathering in Houston from March 6-10 provided a forum for OPEC and non-OPEC oil ministers to engage with the industry’s leading oil experts as well as U.S. and international executives. At the same time, forthright discussions during the conference sessions unsettled markets at times.

Saudi Arabia’s Minister of Energy, Industry, and Mineral Resources Khalid al-Falih commented that the kingdom would only support the OPEC agreement for a “restricted period of time” and cautioned that “the oil market should not get ahead of itself. Don’t believe in wishful thinking that OPEC would underwrite the investment of others by perennially supporting the market.” His remarks appeared directed not only at other OPEC and non-OPEC producers but also shale oil producers, who have been the main beneficiaries of lower OPEC production as they ramp up output in line with stronger prices.

When prices started to tumble on March 8, Saudi Arabia and Russia quickly arranged a press conference to reassure markets of their commitment to the agreement. However, Russian Energy Minister Alexander Novak’s rather modest comment that the country will work toward reaching its 300 kb/d pledge in coming months compared to its current reduction of just 120 kb/d had the unintended consequence of signaling its weak commitment to the agreement. At the same, Iraq further undermined market confidence in the agreement by announcing during CERAWeek that it plans to raise production to 5 mb/d by the end of 2017, a steep 600 kb/d increase above current levels of around 4.4 mb/d.

While Saudi Arabia’s attempt to provide a more positive market narrative was less than successful, CERAWeek did provide an opportunity for OPEC to extend an olive branch to U.S. independent producers of tight oil. OPEC Secretary General Mohammad Sanusi Barkindo held a private dinner with around 20 U.S. shale executives, but this was viewed only as an opportunity for the parties to gain better understanding of each other’s oil outlook. U.S. anti-trust laws prohibit any form of collaboration among oil producers to manage markets. Nevertheless, both parties need each other. Shale oil firms need OPEC to lower production in order to decrease the high oil stocks that have depressed prices and OPEC needs the shale firms to restrain production in order to balance supply and demand. There was a general consensus in Houston that a stronger and earlier than expected rebound in shale oil production is underway, which could slow the rebalancing, but the pace and depth of the recovery remains uncertain. The question is how can shale oil producers and OPEC accommodate each other and raise production in a measured way. Both parties have learned from bitter experience that if they flood the market, they will both be the losers.

OPEC: Options Ahead

The market is now asking if OPEC ministers will extend the production cuts for the second half of the year when they meet on May 25 in Vienna, and if so, will the non-OPEC countries continue to participate given their initial poor compliance. Saudi Arabia, OPEC’s de facto leader, has been in full damage control mode since prices started their downward spiral in mid-March. After commenting during CERAWeek that it was too early to make a decision on extending the agreement, Falih has since indicated that an extension of the cuts for the rest of the year is all but assured. During an interview with Bloomberg on March 16 Falih said that OPEC would extend the cuts past their June expiration at the May meeting if oil stockpiles were “still above the five-year average.” Current data suggest that the earliest the five-year average will be reached is the end of 2017, so his comment confirmed to markets an extension, at least for OPEC, is expected. Between now and the end of May, the market will be looking for confirmation of improved compliance by non-OPEC countries, especially Russia, as an indicator as to whether the producers outside OPEC will follow and extend their production cut commitments. Oil markets will be closely watching the April oil market reports for solid data showing global oil stocks are at last turning lower.

However imprecise, OPEC, Russian, and shale production as well as inventory data will dictate the price trajectory in the coming weeks and months. Solid data is confirming that a massive build up of oil stored on floating tankers has been drawn down now and that oil supplies on the water en route to consuming markets are declining, which will eventually lead to a drawdown in stocks. However, more time is needed to see the full impact of the OPEC and non-OPEC production cuts on U.S. and global inventories.

OPEC May Get Much-Needed Support from Demand Growth

Equally, while market attention has been squarely focused on oil supplies, global demand growth is set to play an increasingly important role in balancing markets and supporting oil prices. Global oil demand growth is projected to steadily accelerate in the months ahead, posting sharp increases on a quarterly basis throughout the year, which should support stronger markets. Indeed, in the first quarter of 2017 global oil declined by a sharp 1.2 mb/d from the fourth quarter of 2016, which added further downward pressure on oversupplied markets and hence prices. However, demand is projected to rise from the traditionally weaker first quarter by 600 kb/d to 97.3 mb/d in the second quarter and by a steep 1.7 mb/d to 98.6 mb/d in the seasonally stronger third quarter. By the final three months of the year, demand growth is projected to rise a further 630 kb/d over the previous quarter, to a record 99.2 mb/d.

And for once, data revisions may work in OPEC’s favor given the history of upward adjustments to global oil demand. A recent analysis shows that the IEA has consistently underestimated demand growth by a significant 900 kb/d a year for the past seven years. The EIA has a history of upward revisions by an even sharper 2.3 mb/d a year over the same period, according to the report, but the IEA is more widely used by the industry. The sharp revisions in part reflect the fact that more than half of global oil demand is in non-OECD countries where there is an acute lack of accurate and timely data available. Almost all of oil demand growth is forecast to take place in non-OECD countries, especially in Asia, so the poor data available make the forecasts prone to revisions.

Indeed, accelerating global oil demand growth looks set to provide some much-needed support to OPEC as it struggles to manage a rebalancing of oversupplied markets with its fragile production agreements and search for a Goldilocks price band that will moderate shale oil production growth.