Money Matters

Shale is back in charge as Opec chooses to watch and wait

March 12, 2018
By David Sheppard and Anjli Raval

Is Opec on the verge of making the same mistake all over again?

The cartel managed to ignore the rise of the US shale industry at the start of this decade until its output growth eventually overwhelmed the oil market. That triggered one of the biggest price collapses in history as Opec fought fire with fire, opening the spigots to try and drown out its upstart competitor.

But for the past 15 months Opec has returned to market management and supply cuts, in alliance with Russia, after the price collapse from $100 to $30 a barrel became too painful for its members to bear. The result has been stronger oil prices but also the rejuvenation of the shale industry.

US output has reached record levels above 10m barrels a day and is now expected to reach 11m b/d by the end of this year.

The growth is coming much faster than many initially anticipated, with the US Energy Information Administration revising up forecasts month after month as the industry becomes more adept at squeezing additional barrels out of each new well.

Its forecast for average US crude production in 2018 has leapt 800,000 b/d in just six months, riding a wave of stronger prices.

Opec, like in 2010 to early 2014, is back to acting like this is not an issue.

Demand, they argue, has been spurred on by three years of low prices and a booming world economy, so is growing fast enough to absorb these new barrels. They still talk as if their own supply deal, which has removed about 1.8m b/d from the market, could be slowly wound down next year.

The industry increasingly begs to differ.

Ryan Lance, ConocoPhillips chief executive officer, warned this week that Opec would need to maintain supply constraints into 2019, telling Bloomberg TV that US shale would “consume most of the incremental demand in the market today”.

It is a view echoed by the International Energy Agency, which sees the growth of US shale — and other non-Opec output from countries such as Brazil and Canada — meeting virtually all of the demand growth up to 2020.

That puts Opec in an uncomfortable position. It has won the confidence of markets by managing to stick to its supply constraints and has undoubtedly succeeded in mopping up the worst of the oil glut.

Hedge funds have backed them in record numbers, buying up crude future contracts in anticipation of higher prices ahead, happily earning a small yield along the way from oil’s move into backwardation — when forward contracts trade above later dated ones in a sign of tightening supplies.

Prices back above $60 a barrel have also kept members and allies happy and compliant, even as some — including Iraq and Russia — are champing at the bit to bring new projects online.

But Opec’s options are now decidedly limited, which goes a long way to explaining why members appear ostrich-like when addressing the state of the market.

The cartel can choose, as seems likely, to keep supporting the price but this will mean finding a way to extend its supply cut deal while at the same time accepting it will concede market share to rivals.

Saudi Arabia, which is preparing the initial public offering of its state oil company, Saudi Aramco, is likely to favour this option as it wants a crude price that is strong enough to let the listing fly.

Riyadh will need to lean hard on its energy alliance with Moscow, orchestrated at the highest levels of the Saudi Arabian and Russian governments, to keep them on board for another year if this is the route they choose.

Some think the Aramco listing, ordered by Crown Prince Mohammed bin Salman as the cornerstone of his plans to develop the country, could be clouding the judgment of experienced oil hands in the kingdom.

In the meantime, Opec is playing an almost passive role as it watches to see how the market plays out.

It is pinning its hopes on demand growth being even stronger than the lofty levels already predicted, that the expansion of shale somehow disappoints, or that traders look beyond the next year or two and see that minimal investment in conventional projects since could be storing up real supply problems further down the line.

Whether this turns out to be a replay of their mistake at the start of this decade, when holding prices above $100 a barrel for too long gave birth to shale, remains to be seen.

What is clear is that there is little appetite in the cartel for a return to their brief flirtation with free markets, of taking shale on through size and volume at the expense of price.

That’s handed the initiative to rivals. Shale is back in charge and Opec is once again choosing to watch and wait.