Posted on December 03, 2016

On 30 November, OPEC agreed to cut output by 1.2m barrels per day to 32.5m barrels, effective from 1 January 2017. The agreement is for a period of six months, but could be extended by six months at the next OPEC meeting in May 2017. Furthermore, an agreement appears to have been reached with non-OPEC countries.

Russia’s energy minister said it would cut production by 300k barrels per day (b/d) and a meeting in Doha this week between OPEC and non-OPEC producers could lead to an additional 300k barrels of non-OPEC cuts. The announced agreement involves deeper cuts and more details of where those cuts are going to come from than expected. As a result, the market response was highly positive and oil prices rose by 8.8% to USD50.5 per barrel from USD46.4 the day before the meeting. Going forward, the outlook is more bullish for oil prices as a result of the OPEC agreement. However, there is a risk that the agreement may not be fully implemented. Therefore, we examine two scenarios. First, we look at the implications for prices in 2017 if OPEC and non-OPEC cuts are fully implemented and second, we look at expected prices if production remains at current levels.

The first scenario assumes that OPEC cuts production to 32.5m b/d for the whole of 2017 and non-OPEC countries cut production by 600k b/d from current levels. Based on data from the International Energy Agency (IEA), the global oil market has been oversupplied by 600k b/d on average in 2016. The cuts proposed in last week’s agreement would reduce world oil production by around 900k barrels on average in 2017, compared with the average production in 2016. This would wipe out the current supply glut. Additionally, the IEA expects global oil demand to grow by 1.2m barrels in 2017. Therefore, the global oil market would shift from excess supply of 600k b/d in 2016 to undersupply of 1.6m b/d. As a result, we would expect prices to average USD60/b in 2017, an upgrade of about USD5/b from our previous forecast. At this level, it is likely that marginal producers, namely US shale oil producers, will begin coming back into the market, which we expect to cap prices at around USD60/b.

In the second scenario, we assume that compliance with last week’s agreement is weak, with no cuts by OPEC from current levels and non-OPEC production rising in line with expectations before the OPEC meeting. Under the scenario, the market will remain oversupplied by 500k b/d in 2017, but the excess supply will be reduced. As a result, prices are expected to rise to an average of USD55/b in 2017 from an USD45/b in 2016, in line with our previous forecast.

The actual outcome is likely to be somewhere in between. Full implementation is unlikely for a number of reasons. First, while core OPEC countries typically comply with quotas, a number of other countries have a history of slippage. Second, Nigeria and Libya were not included in the OPEC agreement as production is expected to increase after recent disruptions, offsetting cuts elsewhere. Third, with regard to the cuts in non-OPEC countries, OPEC has little oversight or sway and the pressure to comply is, therefore, relatively weak. Finally, oil producers have suffered constrained budgets for the last 2.5 years. The temptation will be strong to open the taps a little to get the money flowing again.

Therefore, we expect some cuts to be made, but probably not to the full extent proposed by OPEC. Given that the rebalancing of the market is already underway, production cuts could lend further support to prices. We expect oil prices to average in the range of USD55/b to USD60/b in 2017. However, prices are likely to be capped at around USD60/b as US shale oil producers come back into the market. The success of OPEC’s implementation of the current agreement will be the key to ensuring oil prices approach the upper end of our forecast range.