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Nick Cunningham is a freelance writer on oil and gas, renewable energy, climate change, energy policy and geopolitics. He is based in Pittsburgh, PA.

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Will A 9-Month Production Cut Extension Be Enough?

Oil prices surged on Monday after Russia and Saudi Arabia said they support an extension of the OPEC/non-OPEC production cuts. Oil prices have clawed back a lot of the losses exhibited over the past month, with Brent now safely in the low-$50s and WTI on its way toward those levels.

The joint announcement from Saudi Arabia and Russia, the two most important negotiators, effectively extends the cuts, although the official move won’t come until the May 25 meeting. While it is possible that other OPEC or non-OPEC members might balk at the move, it remains highly unlikely given that most are anxious for higher oil prices. And in any event, Saudi Arabia has always been the one to take on the lion’s share of the burden.

The extension was widely anticipated and the announcement merely squashed some of the uncertainty ahead of the Vienna meeting later this month.

However, what really took the markets by surprise on Monday was the support for a nine-month extension rather than just an extension through the end of the year. “The agreement needs to be extended, as we will not reach the desired inventory level by end of June,” Saudi energy minister Khalid al-Falih said in a statement. “Therefore we came to the conclusion that ending will probably be better by the end of first quarter 2018.”

And in an effort to bolster the production cuts, the OPEC/non-OPEC coalition is working on bringing new countries into the fold, including Egypt and Turkmenistan, although it is unclear if they will be successful. To be sure, some contributions from Egypt and Turkmenistan – with a combined total output of 700,000 bpd – would not significantly alter the pace of adjustment, but their participation would add a psychological jolt to the market. Related: Floating Oil Storage Down By A Third: OPEC Source

"I think OPEC and Russia recognize that in order to get the market back on their side they will need 'shock and awe' tactics where they need to go above and beyond a simple extension of the deal," Virendra Chauhan, Singapore-based analyst at Energy Aspects, said in a Reuters interview.

Although the markets were generally ebullient, questions remain. Let’s assume that everyone is on board and continues to rather impressive level of compliance. The reason for the nine-month extension is that the cuts are bringing inventories down at a much slower rate than originally anticipated. Bloomberg Gadfly notes that even extending the cuts through December would only bring inventories down by just 722,000 bpd for a total reduction of about 120 million barrels. That is less than half of the 276 million barrel surplus that existed just in OECD countries at the end of the first quarter.

Much of the reason for that is higher U.S. shale production – which is coming back much quicker than expected. Last week OPEC itself revised its estimate for U.S. shale production in 2017. OPEC now expects the U.S. and other non-OPEC countries to add 950,000 bpd this year, an upward revision of 64 percent compared to the previous month’s projection. It is hard to overstate how shell-shocked the group has been by the swift return of oil supply in the U.S. As recently as January, OPEC only expected the U.S. and other non-OPEC countries to add around 100,000 bpd this year. Four months later, after strong gains from the Texas shale patch, it revised that figure up to 950,000 bpd. No wonder it now sees an extension of its cuts as necessary. Related: OPEC Cuts Move West

Perhaps nine months will do the trick. But one problem is that keeping everybody in compliance with the cuts will grow more difficult over time. Russia typically ramps up production in summer months as operations can resume following cold winters. “[W]e are skeptical about Russia's willingness to actively participate in any extended cuts,” Carsten Fritsch, an analysts at Commerzbank, told Reuters.

Also, Iraqi officials have suggested that they will be able to ramp up their production capacity to 5 million barrels per day later this year as new fields come online. Then there are the exempt countries – namely, Libya and Nigeria – that have no barriers in their way (aside from serious domestic troubles) to ratcheting up output this year. So, while extending the OPEC/non-OPEC cuts for nine months is a welcome development, some are wondering whether the cuts need to also be deeper.

But that isn’t in the cards for now. Saudi Arabia and Russia are betting that an extension through the first quarter of 2018 will do enough to chip away at inventories, providing a floor beneath prices, but not boosting them so much that U.S. shale comes back even quicker than it already is. It’s a difficult needle to thread, but that is arguably OPEC’s least bad option.

By Nick Cunningham of Oilprice.com

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