OPEC’s rebalancing continued in Vienna on May 25, with OPEC president Khalid Al-Falih saying that an alliance of OPEC and non-OPEC members agreed to extend production cuts for nine months in an effort to reduce the global oil glut and lift prices.

Al-Falih, Saudi Arabia’s minister of energy, said at a press conference that six months would bring OPEC the rebalancing it wants but that the cuts would be given extra time to take root.

“However, it will coincide with the seasonal demand declines starting the first quarter and going into the second quarter,” Al-Falih said. “If we were to lift the production limits, then we could have a sizable stock build in the first quarter, so the nine months will avoid that.”

For the most part, the news matched analysts’ predictions, although word of both shorter and longer extension cuts and variations on how much to cut were in play. Ultimately, OPEC agreed to sacrifice market share for price increases.

The extension could mean an oil market “undersupplied by close to 1 million barrels per day (bbl/d)” with inventories falling by 300 MMbbl by March 2018, Bernstein Research said.

Global inventories have remained glutted despite six months since OPEC began to throttle back production in the first half of the year. Large volumes of floating storage, weaker-than-expected demand in places like India and increased U.S. production have all been cited as factors.

The oil and gas industry has been working to rebound from a downturn brought on by abundant supplies, which have outpaced demand and caused oil prices to plummet from more than $107/bbl in the summer of 2014 to about $26/bbl in February 2016.

It wasn’t until OPEC members agreed in November 2016 to slow production that market conditions began to stabilize after two years of cash-strapped oil companies shedding employees and finding leaner ways to operate.

Led by the Permian, U.S. oil production from shale plays is forecast to increase again, jumping 122,000 barrels per day to 5.4 million barrels per day (MMbbl/d) in June, according to the latest drilling productivity report from the U.S. Energy Information Administration. Oil production in the Permian alone could reach about 2.5 MMbbl/d.

“It all comes together in the inventories, which have been stubbornly high in the last 18 months as a result of three years of accelerated investment in the upstream and a much higher growth in supply capacity than growth in demand,” Andrew Slaughter, executive director for Deloitte’s Center for Energy Solutions, told Hart Energy. “You add up the supply numbers from whatever source. You add up the demand growth numbers and if they’re out of whack, you see that in the inventories.”

Watching Inventories

Inventories need to come down to their five-year historical average, maybe lower, he added. Deloitte expects the market will depend more on inventory drawdowns than trends in U.S. production, which the firm believes “will not offset OPEC cuts despite rig count growth and swelling drilled and uncompleted well inventories.”

Leading up to the meeting, OPEC toyed with various scenarios, including 6-month, 9-month and 12-month extensions as well as revisiting the Nov. 30 decision to cut production by 1.8 MMbbl/d—including 1.2 MMbbl/d from OPEC.

Nigeria and Libya will remain exempt from cuts while Iran’s output was unchanged.

Demand is expected to pick up in the second quarter, as it did in April and May, avoiding a stock build, Al-Falih added. But that doesn’t necessarily mean another extension is off the table, according to OPEC.

“If we see in November that the fundamentals would require us to extend, we’re open,” Al-Falih said. “We’ll do whatever is necessary, and that certainly includes extending the nine months further—whether it’s three months or more. But we will cross that bridge when we get to it.”

Perhaps helping alleviate high supplies is the typical, higher second-half seasonal demand, driven by the Northern Hemisphere’s driving season and crude runs stocking up for winter heating.

OPEC’s actions show they “will continue to put the brakes on supply. Demand increases will also help to rebalance,” Slaughter said.

“You expect demand in the second half of the year to be maybe a million to a million and a half barrels higher than the first half of the year. That’s on top of normal growth,” Slaughter said. When these two factors are added together, it could take between 150 to 225 days to get inventory levels back to a normal range, Slaughter added. But that depends on the actual demand and the level of compliance, which have been “pretty good” in his opinion.

Al-Falih pointed out that OPEC’s compliance with cuts was 102%.

“Clearly the game in town is to keep the lid on supply and work off the inventories,” Slaughter said.

Although actions by the 14-member OPEC group, which now includes Equatorial Guinea and a Russia-led coalition of 10 non-OPEC producers was celebrated as a sign of the what is possible with cooperation, the market appeared to want more.

Reaction, Risks

Despite the agreement, two benchmark crudes, Brent and West Texas Intermediate, were both down by at least 3% during the day —their biggest percentage decline in three weeks.

John Kilduff, partner at energy hedge fund Again Capital LLC in New York, said in a Reuters report that the market is witnessing a classic “buy-the-rumor, sell-the-news” cycle.

“This time, however, the news was disappointing, with the Saudis unable to persuade their oil producing colleagues to cut more,” he said.

Jeff Quigley, director of energy markets for Stratas Advisors, added “the market was not impressed by what happened today.” He believes the market overreacted, saying the fundamentals are starting to move in the positive direction.

Yet, there are still risks, and the biggest ones—in the analyst’s opinion—were not addressed at the OPEC meetings. These risks include production growth from Nigeria, Libya and certain non-OPEC member countries, including Kazakhstan, Quigley said during a webcast following the meetings.

“Their resurgence, production wise, is one of the key risks to the market right now, specifically Nigeria,” Quigley said.

It’s possible that OPEC can hit its five-year stock average goal, but it won’t be easy, according to Quigley. The market needs to draw about 20 MMbbl per month, or about 650 Mbbl/d, to hit the target by year-end, he said.

“We are starting to see some structural pickup in demand in gasoline and distillate worldwide,” he said, adding that combined with rising cost inflation are variables that make the goal achievable. “There is a path to rebalancing this market.”

However, he added an extension beyond March 2018 may be necessary. “We believe there will be a surplus, even in second and third quarters,” due in part to expected increases in U.S. production.

Oil Price Outlook

What that means for oil prices nine months from now remains to be seen.

Deloitte still expects prices to remain reasonably firm in the low to mid $50s, Slaughter said, noting they will creep up as inventories draw down.

OPEC’s decision shows a commitment to support oil prices into 2018, according to Ann-Louise Hittle, vice president of research macro oils for Wood Mackenzie.

“The extension through to the first quarter of 2018 makes it clear to the oil market that OPEC intends to continue to support oil prices at the expense of market share, at for the time being,” Hittle said in a statement. “For 2017, the OPEC decision today does not make a large difference to our oil price forecast. Our view since January has been that cuts would be extended through end 2017, and that fundamentals tighten in the second half of 2017.”

The firmer oil price supports the U.S. tight oil industry, helping shale drillers make plans, Hittle added.

But John Hartung, a U.S. oil and gas strategy principal for EY, pointed out a potential pitfall for U.S. drillers.

“One possible hurdle for shale is that increased activity and more stable prices could lead to inflation in costs and services. Producers will need to ensure that inflation does not outstrip hard-earned efficiency gains,” Hartung said in a statement. “As U.S. oil supplies surge, the country’s demand is flat. … Unless we see significant growth in demand or an unexpected shock to supply, we’ll continue to see oil prices fluctuating in a narrower range in the short term—with a ceiling set by US shale production growth.”

Quigley added that OPEC continues to see rising shale costs as an optimistic case, and that there’s reason to believe that this will continue to drain inventories and raise marginal prices.

Stratas believes that is true as well, he said. We think the market is undervaluing this possibility. We think the market is a little too optimistic about what shale can do.

Velda Addison can be reached at vaddison@hartenergy.com.