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News that an agreement to cut OPEC production was reached came as no surprise, as the hype surrounding the November 30 meeting would have led to a price collapse if a deal was not struck, especially in light of the Algiers agreement to cut back in September.

Fear of this potential collapse was sufficient to sideline the real and deep divisions between Riyadh and Tehran that go far beyond oil. Some form of agreement, no matter how anodyne was essential and, as expected, the market immediately responded positively with typical irrational exuberance as Brent quickly moved above $54 per barrel. 

But a more careful reflection suggests that the deal is unlikely to support prices much higher for any period of time, due to several factors.

Non-OPEC support is essential

It appears a cut of 600,000 b/d (barrels per day) is required from Non-OPEC if the agreement is to be honoured, and the record of such agreements between OPEC and Non-OPEC has been pretty abysmal.

They are often rapidly reneged on with the classic example being March 1998 when Russia, Mexico, Oman and Norway agreed to support an OPEC cut but only Oman delivered.

The expectation this time is that Russia will cut by 300,000 b/d but, according to Russian oil minister Alexander Novak, production can only be reduced “gradually” because of “technical issues”.  This smacks of getting one’s excuses in first.

Something positive must now come out of the planned meeting between OPEC and non-OPEC in Moscow on 9 December for the same reason an agreement was needed on November 30 - failure would trigger a price collapse.

As 2017 unfolds, compliance is likely to weaken

OPEC’s record on quota compliance has been notoriously poor ever since the first quotas were introduced in March 1982 with an agreement that lasted less than a few weeks.

A famous OPEC moment came in 1997 when the Venezuelan minister of oil, under severe attack in the closed ministerial meeting for supposedly 'cheating' eventually declared in frustration 'we admit we are over-producing, that is not cheating.'

To give a flavour of what to expect - before the (failed) Doha meeting in April aimed at freezing production at January production levels, both Kuwait and Iraq grossly overstated their January production levels to allow 'wriggle room' in the event of a freeze.

The only realistic question is how soon will the cheating begin?

Supply response is dramatically changing

Thanks to the shale technology revolution, the responsiveness of supply to price has increased significantly. Conventional oil supply faces lead times of five to ten years or longer. For shale/tight oil the lead-time is a matter of months.

In addition, there are a large number of wells in the US that have been drilled but not completed - the so-called 'fracklog'. Already the higher prices seen since the Algiers accord in September have led to an increase in drilling and fracking activity. Prices much above $50 per barrel will rapidly increase supply to choke off further increases.

In reality, the crude oil market has been struggling with over-supply since mid-2014 anyway, driven by a need for Arab oil producers to get higher prices in order to buy off internal political unrest since the Arab Spring back in early 2011.

These higher prices (from 2011-13, Brent averaged $110.53 per barrel) created feedback loops in the market: demand destruction and, in a world where the shale technology revolution was spreading, increased supply.

Inevitably this over-supply created downward pressures on prices as inventories reached record levels. In November 2014, Saudi Arabia adopted a new strategy aimed at taking market share from the high cost producers by refusing to cut production to defend price.

The resulting price collapse saw Brent fall from $111.80 in June 2014 to 30.70 in January 2016 but, since then, Saudi Arabia appears to have been backing away from this strategy. It has been trying to secure an agreement with the rest of OPEC and some key non-OPEC producers - initially to freeze production, but more recently to cut it.

In September, at the Algiers OPEC meeting, a cut was agreed but no details released. On November 30, more details were agreed and the 'deal' was announced to cut OPEC production by 1.2 million barrels per day (mnb/d) from January 1.

It appears Saudi Arabia will make the largest cut (486,000 b/d), followed by Iraq (210,000 b/d) the UAE (139,000 b/d) and Kuwait (131,000 b/d). Other OPEC members have agreed to reduce production by very small amounts, with the exception of Nigeria and Libya (who are excluded) and Iran (who is allowed to increase production  by 90,000 b/d).

However, the agreement is conditional upon Non-OPEC agreeing to cut by 600,000 b/d, and the oversupply that caused the price collapse and is reflected in record levels of inventories still remains in place.

The precise extent of the over-supply is not clear, simply because oil market data are extremely unreliable. But it seems likely that OPEC’s recent over-production means the balancing of the market is now even further away.

It is effectively a receding horizon and, until that inventory overhang disappears, the market cannot support much higher prices and enthusiasm for the deal is misplaced.

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