The ruinous tussle for market share between tight oil producers in North America and, in the main, members of Organization of the Petroleum Exporting Countries, OPEC, saw crude oil prices slump by more than 70% from the second quarter of 2014 to twelve-year lows in the first quarter of 2016. Prices have rebounded somewhat, driven by a production reduction accord reached on Nov. 30, 2016. The accord which was reached by twenty-four OPEC and non-OPEC producers aimed to rebalance the oil market by reining in the massive supply overhang.

There are indications that the accord may be having its intended effect on the oil market. With the narrowing of the spread between front month and second month for the U.S. benchmark for example, traders that had bet on contango - having stored oil lots bought cheaply with a bid to sell later at much higher prices - are finding it increasingly less profitable to keep the lots in storage. And so, from storage such as in the Gulf of Mexico and South Africa, crude oil is slowly being shipped out.

While there is a perception that global oil market rebalancing is on track, there are issues that may derail the process; and these four are informative.

Accord Compliance

The aggregate compliance rate for the first month of that production reduction accord was high, though some of the production cuts agreed under the accord represent natural production declines which would have happened with or without the accord. Non-OPEC compliance was about 50% while that of OPEC stood at about 97%. However, it is anyone’s guess if that compliance rate - or even any significant rate - can be sustained, especially where there are neither credible production records nor effective sanctions for production violations. In the case of OPEC, for example, production cuts were allotted to members based on October production figures derived from secondary sources. However, according to an analysis by Petroleum Economist (subscription required), Iraq, which claims that her October output was at least 250,000 barrels per day (bpd) higher than the basis for her allotted value, only cut production by 109,000 bpd, about 52% of the pledged 210,000 bpd in the first month of the accord. In addition, records show that the country’s exports increased in February. Angola is also reported to have fallen short of her pledged reduction target for the month of February.

Some analysts hold that the accord needs to be rolled over for another term of six months if the market is to reach a balance by the end of the year. Such leakages would certainly not aid that rebalancing bid; and neither would the consequent return of U.S. shale producers (see below) if the accord significantly lifts oil prices.

U.S. Shale Output

Crude oil output by shale producers in the U.S. has been on the upswing since last year, after the slump which began in 2015. In the last four months, output increased by about half a million barrels per day; a steeper climb rate than the previous rollout, this undoubtedly is mitigating the effect of the production reduction accord. The output ramp-up was driven by an aggregate 46% decline in operating costs, per Rystad Energy.

That decline in turn was overwhelmingly due to falling unit costs (personnel, material, services, etc.) but also due to structural (high-grading, etc.) and operational (enhanced drilling, etc.) factors. A rise in oil prices would most likely see unit costs increase also. OPEC has expressed its preference for oil prices in the US$50 – US$60 per barrel range; but many analysts hold that a lot of shale producers can also remain profitable with oil prices in that range. There are reports about meetings between OPEC and U.S. shale producers aimed at reaching a production consensus. It remains to be seen how that will turn out. While some Gulf producers have production breakeven prices as low as US$12 per barrel, their budgetary breakeven prices go as high as US$90 per barrel.

If sustained, the increasing shale output would most likely render the production accord ineffective, bringing down oil prices and upending the global rebalancing process. Furthermore, if oil prices fall well below US$40 per barrel, the future of shale investments could be severely affected.

Stocks and Balance

Global crude oil inventories are still at the high end. In the U.S., commercial stocks for the week ending March 3 were 8.2 million barrels higher than those of the earlier week and 37.6 million barrels higher than year-earlier levels, according to data from the U.S. Energy Information Administration (EIA). The values were also above the upper limit of the average range for this time of year. Gasoline inventories were near the upper limit of the average range for the season.

The outlook for global crude oil demand is middling at best. China, a major consumer recently cut her economic growth target to 6.5% from 6.7%. Policy uncertainties associated with Brexit, the new U.S. administration, elections in Europe particularly, France and Germany are weighing on the outlook for the global economy. The Organization for Economic Cooperation and Development (OECD) in a recent report expressed concerns about global economic stability. The rise of anti-establishment politics in Europe, increases in rates by central banks, economic tariffs such as those proposed by U.S. president Donald Trump were all possible de-stabilizers.

With such demand outlook, it is unlikely the high global inventory levels would be depleted any time soon to bring about a stable global oil balance.

 Exigencies

When oil supply routes or production sources for example are impacted, choke points and supply outages may arise. Islamic fighters, for example, on  March 3 attacked the Libyan oil port facilities at Ras Lanuf and Es Sider. The OPEC member which saw output recover last month to about 700,000 bpd following similar conflicts, now risks further supply outages.

Of greater concern, however, is the increasing risk of military confrontation between global super powers, U.S. and Russia, and its effect on the Persian Gulf. The Strait of Hormuz (between Gulf of Oman and the Persian Gulf) for example, holds a significant proportion of global sea-borne oil trade and its closure would shut out a large quantity of oil. The market would then flip from a supply overhang to a massive supply shortfall, contributing inevitably, to a price shock. Both extremes are certainly undesirable.

There has been an escalation in the number of intercepts, buzzings and fly-bys, not only in the Persian Gulf but in the Baltic Sea as well as over Syria. Whether it is a proxy war or a fight for global influence, this sabre-rattling could easily flare up to full combat, a situation that holds dire consequences especially for the oil market. There has also been an increase in the risk of conflict between the U.S. fleet and Iranian gun boats in the Persian Gulf; and even this can cause significant supply outages.

All said, crude oil prices tumbled last Wednesday to their lowest level since that accord, driven by net inventory builds, a poor demand outlook and increased output by U.S. shale producers. There is now the uncertainty over the willingness of largest OPEC producer and main driver of the accord, Saudi Arabia to allow ‘‘free riders’’ - a reference to mainly shale producers who are not contributing to the supply cut - benefit from the oil price rise. OPEC is scheduled to meet again in May, to review the production accord; and the outcome of that meeting will largely determine the oil price trajectory and therefore the global oil balance.

Except for a major exigency, crude oil prices in the near-term would at best be range-bound. Shale producers in the U.S. were over the moon when the oil supply accord began to lift prices; but they may just be like Jean-Joseph Rabearivelo’s receding moon, a moribund lapidist on his own unnoticed grave.