(John Kemp is a Reuters market analyst. The views expressed are his own)
* Chartbook: tmsnrt.rs/2svKweE
By John Kemp
LONDON, Feb 14 (Reuters) - “The lexicon of exit is not found in our vocabulary”, OPEC Secretary-General Mohammad Barkindo told reporters on the sidelines of a conference in Cairo on Monday.
Ministers from the Organization of the Petroleum Exporting Countries have been anxious to counter speculation about an early end to production curbs.
Barkindo was reinforcing the message that the current curbs will be maintained until at least the end of this year and could be continued into 2019 (“Barkindo stresses ongoing cooperation, not exit”, Argus, Feb. 12).
OPEC will review progress towards its goal of eliminating excess global inventories at its next regular meeting in June, but ministers have downplayed suggestions the review could lead to an early exit from the accord.
The Declaration of Cooperation signed in December 2016 between OPEC, led by Saudi Arabia, and selected non-OPEC producers, led by Russia, has become fundamental to OPEC’s strategy for managing the oil market.
Both sides appear satisfied with the results achieved so far and keen to extend their cooperation in the medium term.
Global oil inventories have been cut to just over 100 million barrels above the five-year average, down from 340 million at the start of 2017.
Benchmark Brent prices have risen by around $20 per barrel, or almost 50 percent, since the production cuts were announced, and futures prices have swung from contango into backwardation.
Saudi Arabian Energy Minister Khalid al-Falih and his Russian counterpart Alexander Novak are “apostles to the value of cooperation”, Barkindo told a separate conference in Riyadh on Wednesday.
“They have proven to be the key strong pillars on which the historic OPEC and non-OPEC cooperation has been built” (“Introductory remarks by secretary-general”, OPEC, Feb. 14).
The agreement between 24 OPEC and non-OPEC oil producers is therefore likely to be extended and evolve rather than terminated.
In that sense, Barkindo is correct to note exit is not on the agenda. The critical question is how and when the agreement is modified not whether it is ended completely.
The most likely outcome is that the agreement is eventually adjusted to include a new set of higher production limits while maintaining the framework of regular meetings between OPEC and non-OPEC producers.
But with Saudi Arabia and Russia among the only signatories that have the capacity to boost output and benefit from higher production limits, securing a broad agreement is likely to prove tricky.
Production restraint has been far more successful in drawing down excess global oil stocks than most analysts expected or indeed OPEC itself originally expected (“Egypt petroleum show”, OPEC, Feb. 12).
Crude oil stocks remain around 100 million barrels above the five-year average, but if they were pushed down to that level the oil market would almost certainly feel very tight, given the growth in consumption since 2013.
Stocks of refined products are already close to the five-year average, and in some cases below it, which has left many fuel markets feeling under-supplied.
While OPEC insists stocks need to fall further, by most indicators the oil market has already rebalanced and is now firmly in the tightening phase of the cycle (tmsnrt.rs/2svKweE).
If OPEC and its allies maintain their production curbs too long, oil prices will rise and spur an even more drilling and production from U.S. shale producers.
The most recent forecasts for production and consumption show U.S. shale producers and other non-OPEC suppliers will essentially capture all the forecast demand growth in 2018.
If OPEC and its allies maintain their production curbs, they may secure higher prices, but only at the expense of losing more market share.
The dilemma of whether to prioritise the price defence or protect market share is familiar. OPEC has regularly alternated between price defence and market share protection for 40 years.
Before June 2014, the organisation was focused on protecting prices above $100 per barrel, even at the expense of losing market share to U.S. shale producers.
Between June 2014 and June 2016, the priority shifted towards recapturing market share, at the expense of a wrenching slump in prices.
Since December 2016, the focus has been on cutting excess oil stocks and pushing up prices, even though it has cost some market share, especially in Asia.
The strategy of cutting stocks and boosting prices has been successful, but the costs associated with it are starting to rise as U.S. shale producers capture more and more of global demand growth.
At some point, OPEC and its allies will be forced to shift their focus back towards boosting output and stemming the erosion of their market share. The only question is when.
OPEC and its allies will probably adjust the declaration at some point to include higher production limits with the aim of defending their market share without triggering a steep fall in prices.
The challenge is to get the timing and the scale of the output increase right so the extra supply is absorbing by growing consumption.
But experience suggests OPEC will leave the adjustment too late, tighten the market too much and send prices surging.
The organisation will then increase supply at the moment when non-OPEC supply is accelerating and demand growth is already slowing.
OPEC allowed the market to tighten too much after both the two previous slumps in 1997/98 and 2008/09 with the result that prices overshot its initial targets. Something similar is likely in 2018/19.
The other challenge for OPEC is managing market expectations.
Hedge funds and other money managers have built a record bullish position in crude in the expectation that OPEC and its allies will continue to restrain output and continue to tighten the market well into 2018.
Position-building by fund managers has helped accelerate the accentuate the rise in oil prices and provided an early harvest for OPEC and its allies.
Any sign that producers are preparing to increase their output could trigger a rush to exit from some of those bullish positions and a sharp fall in prices.
Most OPEC members would prefer to tighten the oil market too much and benefit from a short-term revenue windfall rather than risk not tightening it enough and a renewed fall in prices.
Saudi Arabia, the organisation’s de facto leader and the real swing producer, needs relatively high prices to balance the government budget and pay for ambitious social and economic modernisation programmes.
The kingdom also needs high prices to help secure a favourable valuation in the forthcoming sale of sale of shares in its national oil company Aramco.
Most other OPEC members also need higher prices to cut their budget deficits and maintain internal social stability.
Among the non-OPEC signatories to the Declaration of Cooperation, Russia has expressed some reservations about the need to protect market share, but has so far agreed to continue with a price-defence strategy.
Ultimately, most OPEC and non-OPEC members are aware of the dangers of pushing prices too high but negotiating revised production limits will prove tricky.
Saudi Arabia, Kuwait and Russia are probably the only signatories with the capacity to boost their output significantly in the short term.
Other OPEC and non-OPEC members have little to gain from higher production limits and would prefer higher prices instead.
Saudi Arabia and Russia have the ability to raise production unilaterally, or in agreement with each other, but will probably want to maintain the broader framework of cooperation painstakingly built since 2016.
Since negotiating an upward revision of production limits could prove contentious, it is easier for OPEC and non-OPEC producers to continue with the existing agreement for as long as possible.
“U.S. shale surge sends warning to OPEC”, Reuters, Feb. 7
“OPEC’s focus on stocks risks prices overshooting”, Reuters, Jan. 3
“OPEC must think about exit strategy”, Reuters, Oct. 25
Editing by David Evans