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OPEC's 'truce on oil prices' could be quickly shattered by more shale production

Workers tend to a well head during a hydraulic fracturing operation outside Rifle, Colorado.
Brennan Linsley | AP
Workers tend to a well head during a hydraulic fracturing operation outside Rifle, Colorado.

OPEC's promised production deal will probably prop up oil prices, but it may also jump-start more U.S. shale drilling — which would go against the very reason the cartel started a price war in the first place.

Analysts at both Bank of America Merrill Lynch and Citigroup pointed to the possibility that OPEC's move toward a production cut would drive up oil prices, and that might encourage more drilling by the shale industry, which has finally seen rig counts pick up and production levels stabilize after a steep decline.

BofA anlysts said Thursday that flow rates in the Permian basin of Texas and New Mexico have improved in recent months, meaning U.S. shale players are getting more oil out of the ground with better technology.

"Worryingly for the cartel, production in the West Texas region has already started to increase sequentially. Stated differently, OPEC has declared a truce on oil prices. But relentless improvements in shale technology will keep Saudis awake at night wondering if they have made the right choice," the analysts wrote.

"The $45 level was starting to bring them back. They're driving down costs all the way through the production chain," said John Kilduff of Again Capital. But shale drillers could also add more supply to the already oversupplied market, and that would cap gains in oil.

Some industry experts believe more drillers could put rigs back in operation at $50, but in order to see a real resurgence, oil needs to be at $60 per barrel.

"This is not a return to the old OPEC given a new world with shale and lower demand growth." -Citigroup analysts

Oil prices were up over 1 percent Thursday, a day after surging more than 5 percent the promise of an OPEC production agreement. West Texas Intermediate was trading near $48 per barrel. Prices will likely stay range-bound, Citigroup analyst say.

"This is not a return to the old OPEC given a new world with shale and lower demand growth. Sustained higher oil prices all else equal could see US production increase again, and hence limit the oil price move. Put differently, absent a demand driven move, we still think a rather range-bound oil market is in store for us more medium term," wrote the Citigroup analysts.

OPEC has so far only reached a preliminary agreement to strike a deal to cut production by 200,000 to 700,000 barrels a day, from 33.2 million barrels. The breakdown of which countries will trim output is expected to be worked out by its November meeting. But BofA points out that Saudi Arabia normally cuts back at this time of year. the Saudis produced about 10.6 million barrels a day last month.

"After all, Saudi has cut production seasonally by 320,000 (barrels per day) every year between July and January. The move in Algiers may reflect the impending fiscal pressures, as many OPEC government budgets are starved for cash. Also, it is critical to remember that pegged currency regimes across many oil producers have put a huge strain on foreign exchange reserves in key OPEC members," the BofA analysts wrote.

As for the U.S., domestic oil production has been around 8.5 million barrels a day recently, down by about 1.1 million barrels a day from the all-time high in the spring of 2015. In November 2014, OPEC, led by Saudi Arabia, gave up on production levels and opted for a new strategy of letting the market determine oil prices. Producers, from the U.S. to Russia and Saudi Arabia, kept pumping and created a giant oil glut. Oil plunged, and ultimately hit a bottom in February 2016 at just about $26 per barrel.

'Trim on the edges'

Saudi Arabia has more motivation to end the pain of low prices. It is in the midst of carrying out its "Vision 2030" economic program, which is designed to move the country away from an economy that is dependent on oil and where two-thirds of jobs are in the public sector. It needs steady oil pricing right now. BofA said the cartel's actions are now much more likely to lead to a rebalancing of the market, meaning supply and demand will come more in line. That should help oil producers including Saudi Arabia, to get cheaper debt funding over the next few months, BofA said.

The analysts said that because the market could rebalance, they are keeping a forecast that Brent crude will average $61 per barrel in 2017. Brent is the international benchmark and is trading bout $2 per barrel higher than WTI futures.

The BofA analysts also noted that the OPEC cuts shift the risk to the upside for prices, but there is also a wave of potential production coming back not just from Libya and Nigeria, but also from Kazakhstan.

"In essence, we believe (Saudi Arabia) will trim on the edges, but won't propel prices much above our $70 (per barrel) target by end 2Q17," they wrote.

BofA said the cartel has finally blinked and oil prices are now much more likely to rebalance higher, allowing oil producers including Saudi to source somewhat cheaper debt funding over the next few months.