Oil Market: Winding road to rebalancing – BMO CM

Earl Sweet, Head of Economic Risk at BMO Capital Markets, explains that while the path to oil market rebalancing has been volatile, the price of West Texas Intermediate (WTI) recovered sharply over the past year, almost doubling from its low of $26/bbl in February 2016 to an average of $51 so far this year.

Key Quotes

“This reflects strong growth in global demand, earlier low-price-driven declines in U.S. production, and the agreement late last year by OPEC and 11 other producers (OPEC+), including Russia, to significantly restrain output. So far, OPEC compliance with the agreement, at about 95% during the first four months of the year, has been higher than expected. Russia has also phased in production cuts by the agreed amount of 300,000 barrels/day. Yet, prices weakened notably during the second half of April and early May on signs of a rapid recovery in U.S. shale oil output, stubbornly high U.S. inventories, concerns that economic growth in China will slow as the authorities tap the credit brakes, unsettling geopolitics headlines (Syria, North Korea, Russia, Comey Affair) that have spurred general risk aversion, and growing doubt about the U.S. administration’s ability to steer stimulus through Congress.”

“Further, while OPEC+ has cut production, actual shipments from producer inventories built up prior to the agreement had for a time remained buoyant. On top of that, oil output has begun to recover in Nigeria and Libya, two members of OPEC that had been excused from the agreement due to their production having been substantially reduced by insurgency and factional conflicts.”

“With market rebalancing slower than anticipated, there have been signals from OPEC+ participants that they, at their May 25th meeting in Vienna, will extend the production curtailment agreement into the second half of 2017 and possibly the first quarter of 2018, if that is necessary to return global inventories to their five-year average. While oil has rallied moderately on that news, as well as on indications that U.S. inventories are beginning to decline from record-high levels, there is still skepticism about the plan’s success. Much has been written about the prodigious growth in U.S. shale resources, as well as rising production in Canada, Brazil, Nigeria, and Libya. Perhaps the bounce in U.S. output from last year’s lows shouldn’t be that surprising given that it partly reflects the completion of numerous wells that had been drilled but not completed.”

“The U.S. industry has so far taken important steps to optimize its asset base, reduce costs, and attract equity investment and it undoubtedly will be able to develop new resources and raise production over the next several years. However, a successful extension of the OPEC+ agreement through the end of this year, combined with the rising global demand for oil, estimated by the International Energy Agency at 1.3 million barrels/day in 2017, would more than offset increasing output in the U.S. and by other major producers not participating in the OPEC+ agreement. With global demand finally moving above supply, there is a good chance to achieve market rebalancing by the end of this year or early 2018. Once that is achieved, the unwinding of the agreement would have to be phased in to avoid a return to an over-supplied market.”