The big question is whether individual OPEC countries can trust each other. As any undergraduate economics student knows, the incentive to cheat for a cartel member is commensurate with the rise in price. The strength of the deal will depend on the commitment of all its members. So even though the back and forth headlines regarding OPEC policy that we’ve experienced since 2014 may seem to have come to an end, the truth is they probably haven’t.
As the graph above shows, not all of the oil producers are created equal. Oil’s (OIL) (DBO) production cost differs for every oil producing nation. As a result, the incentive to increase production as oil prices (USO) (BNO) spike could be high for nations with higher production costs. It casts serious aspersions on the efficacy of the deal.
Production cuts already started. However, implementation doesn’t mean full compliance as prices start to rise. An important indicator could be the current inventory levels of oil producing nations. OPEC’s agreement urges members to reduce production. However, the level of exports isn’t covered under the deal. Current inventory levels could keep exports high for the first few months.
Another setback could be caused by increased production in Libya. Libya was excluded from production cuts. Its output has been tamped down dramatically by militancy in the area. However, Libya recently stated that reinstated pipelines could help buoy production by 270,000 barrels per day. If this holds true, it would mean negating close to 25% of OPEC’s production cut targets.
If US shale production (XOP) is shored up in response to OPEC’s production cut, it would defeat the purpose of the deal in question. Rigs continue to grow. The number of rigs drilling oil grew by 15 to 323 for the week ending December 23, 2016. It marks eight consecutive weeks of growth in the number of rigs. It’s the highest number since December of last year (Source: EIA, Market Watch).
The biggest setback could come from non-compliance by OPEC members. OPEC members don’t have the best track record of compliance with agreements in the past. As shown in the previous graph, between 1982 and 2009, the OPEC 9 (excluding Iraq) exceeded their oil production quotas in 96% of the months. A sustained spike in oil prices could sway OPEC members from their resolve to cut production. It would defeat the purpose of the agreement.
In the next part of the series, we’ll explore oil’s outlook in 2017.