OPEC+ managed to reach an agreement to cut production by an additional 500,000 barrels per day (b/d) for the first three months of 2020, a move that helped bolster market sentiment and ease concerns about oversupply.
However, a few days after the OPEC+ deal was announced, the IEA warned that the oil market would still suffer from a supply surplus, at least for the first few months of 2020. But mounting problems in the U.S. shale industry could tighten up the market as the year wears on.
How significant is OPEC+ deal?
Oil prices reacted immediately after OPEC+ announced additional 500,000 b/d in cuts, although the price gains overall were relatively modest. Still, in terms of sentiment, the market seems to have undergone a notable shift in early December, boosted both by the news from Vienna as well as from the partial trade deal between the U.S. and China.
Bullish bets on oil futures surged in the week following both deals, the largest shift into net-length from hedge funds and other money managers in more than two years. It’s a clear sign that big investors see the market turning a corner.
But, in terms of the fundamentals, there is debate about the significance of the new cuts. OPEC+ was already producing under the ceiling for the group, as Iran and Venezuela lost huge volumes of production this year and Saudi Arabia continued to over-comply. Russia also managed to get some of its condensate production exempted from the deal.
On the other hand, Saudi Arabia promised unilateral cuts of 400,000 b/d in addition to the 500,000 b/d reduction from OPEC+. Finally, the group pledged greater compliance from lagging members, namely, Iraq and Nigeria.
Despite all the extra effort, the IEA said that the oil market would see a surplus of 0.7 million barrels per day (Mb/d) in the first quarter of 2020. “Even if they adhere strictly to the cut, there is still likely to be a strong build in inventories during the first half of next year,” the IEA said in its December Oil Market Report. If everything goes according to the script, OPEC will cut output to around 29.3 Mb/d in January. “That is still 700 kb/d above the 1Q20 call on OPEC crude and 1 mb/d above the second quarter call.”
U.S. shale slows down
But dire forecasts about chronic oversupply hinge on ongoing robust growth from U.S. shale, an assumption that is now very much in question. As the shale industry added prodigious volumes of new supply over the last decade, the “base decline rate” has surged.
“Base decline is the volume that oil and gas producers need to add from new wells just to stay where they are—it is the speed of the treadmill,” Raoul LeBlanc, vice president of Unconventional Oil and Gas at IHS Markit, said in a statement. “Because of the large increases of recent years, the base decline production rate for the Permian Basin has increased dramatically, and we expect those declines to continue to accelerate. As a result, it is going to be challenging, especially for some companies with cash constraints, just to keep production flat.” Without access to capital, spending cuts from drillers may provide immediate relief to wrecked balance sheets, but the impact will also be felt almost immediately on production growth.
IHS Markit predicts U.S. oil production growing by just 440,000 b/d in 2020, less than half of what the IEA envisions. In 2021, IHS says shale growth will flatten out entirely. Production is already stagnant in just about all shale basins outside of the Permian.
Meanwhile, Standard Chartered disputes the productivity data being published by the EIA. “We cannot find a source from shale oil and gas companies that supports an 18% y/y rise in initial well productivity. The talk among companies is of initial well productivity at best stalling, and at worst falling, due to a variety of technological and geological constraints, particularly in the move from tier one to tier two acreage,” the bank said.
If U.S. shale does not live up to market expectations, the oil market could tighten up by more than anticipated. Goldman Sachs also says that U.S. shale problems could result in an inflection point in the oil market. “We are entering a bottoming phase for Energy equities in 2020, with potential for improving Energy equity sentiment as the year progresses resulting from lower non-OPEC supply growth outlook for 2021,” Goldman analysts wrote in a note on December 2017.
In other words, after years of having to restrain output to prevent an enormous glut of supply, OPEC may finally be called upon to increase production in order to keep crude inventories in balance. “Barring a recession or non-compliance, it is not clear incremental OPEC cuts will be needed” beyond the current agreement, the bank said.