Why a staged and adjustable process is key to Opec’s future

The group and allied countries including Russia agreed to increase oil production by 500,000 barrels a day from January and plan to meet monthly to decide further output levels

Opec+ agreed last Thursday to increase oil production by 500,000 barrels a day from January and said they would meet monthly to decide further output levels, gingerly adding more crude to the global economy still suffering from the Covid-19 pandemic. AFPShow less

Last week’s Opec meeting was the most challenging since April, when the current deal on production cuts came together. In the end, a sensible compromise surmounted the obstacles. Still, the organisation needs to plan ahead for 2022.

The latest meeting was delayed with reports of some tactical disagreements between members. Opec had a range of choices in the face of a worsening pandemic in the US and Europe, forecasts of minimal reductions of overstuffed inventories in the first quarter and a resurgence of Libyan output.

From this coming January, Opec could cut output deeper, an unlikely prospect with some members disagreeing and the oil price already having recovered a little with rising optimism as vaccines are set to be deployed in the UK and other countries. It could bring back two million barrels per day of output, as had been baked into the arrangement since April. The planned increase in production could be delayed until the second or even third quarter. Or, Opec could find a compromise position, and that was eventually what happened.

Output cuts will be eased gradually from January, with the current notional 7.7 million bpd reduced to 7.2 million bpd, followed by monthly meetings to agree whether to add a further 0.5 million bpd each month to April, or to hold off on further increases. The increases are shared among the members in proportion to their baseline production, relatively favouring Russia and Saudi Arabia who were assigned higher benchmarks in the original negotiation.

Although it had been said traders had already priced in an extension of the cuts, oil prices rose on the news of the phased increase, with Brent approaching $50 per barrel for the first time since March. The strengthening of backwardation in the futures curve – with prompt prices higher than for later delivery – will encourage the clearance of excess storage.

Although it means more frequent debate and doubt, this flexible, phased, and monthly approach is sensible in the face of a tangible but uncertain market recovery. The idea will be to avoid a further price slump while continuing to regain market share. That is important for keeping members, who have been chafing at the severity of the cuts, onboard.

Still, it will have to be seen, whether serially under-complying members, such as Russia and Iraq, take advantage of a higher allocation to make up past shortfalls, or whether they simply pocket the gain and continue overproducing.

At this rate of progress, the cuts would be finally eliminated around April 2022. That is indeed the end date for the current deal, though it was not meant to be phased out in this fashion. Instead, the original scheme would have had 5.8 million bpd of cuts remaining by then, with a further likely extension to avoid suddenly overwhelming the market.

The medium-term goal must be to return to the status quo ante of late 2019. That is rendered more difficult by the likely slow and patchy logistics of rolling out several new and demanding vaccines to a large proportion of some 7.8 billion people. It relies on a relative return to “normality”, without a long-term impact of economic damage and changed habits of commuting and leisure and business travel.

On the supply side, it depends on how quickly American shale companies return to drilling in response to stronger prices, whether Libyan output is sustained, whether sanctions on Iran are eased, and whether there might be a revival in Venezuela. S&P Platts expects US crude production to reach a low in the middle of next year before rising again.

In the long-term, the pandemic has been a very unwelcome interruption to the process of Opec adjustment to a new reality. Cuts under the Opec+ framework since the start of 2017 helped support prices after the late-2014 crash, but US shale output remained relatively solid. The organisation was aware of the threat of both US competition and eventual “peak oil demand”.

Since then, the outlook has grown cloudier. At least a year of oil demand growth has been lost. Progress in electric vehicles has continued. BP has proclaimed that we may already have passed the all-time high in oil consumption, while it, Shell, Total, and other petroleum giants have committed to eventual decarbonisation of their businesses. The EU, UK, China, South Korea, Japan, and the incoming Biden administration in the US all have targets for carbon neutrality between 2050 and 2060.

On the other hand, diminishing investment in new production and greater capital discipline by shale firms creates the possibility of at least an interim shortfall. On Thursday, Denmark, the EU’s largest oil producer, said it would cease new exploration and that its hydrocarbon extraction would wind down by 2050.

Making hay while the sun shines, low-cost Opec producers with long reserves lives and favourable investment conditions, could seize the opportunity to boost capacity and market share. The benefits of this go beyond just higher output and revenues: more associated gas, additional investment in the local economy, additional feedstock for petrochemicals, and greater political influence both within Opec+ and on the world stage.

Meanwhile, declining or politically-constrained Opec+ adherents may become discontented. Less significant when the market is under-supplied, their cooperation is still required at times of glut.

The long-term is made up of a series of short terms. Gains in output have to be made in a way that avoids overwhelming the market or storage or triggering a destructive price war. Outlining a staged, adjustable process is the first step.

Robin M. Mills is CEO of Qamar Energy, and author of The Myth of the Oil Crisis