Julian Lee is an oil strategist for Bloomberg First Word. Previously he worked as a senior analyst at the Centre for Global Energy Studies.

The benefits of OPEC's agreement to cut output have proved elusive. With less than three weeks to go before the group's next meeting, something is very, very wrong as far as oil producers are concerned. And they have no easy solution to put it right.

The oil price is not far off where it was in November, before OPEC and friends agreed to cut output -- Brent briefly fell to within 30 cents a barrel of its pre-meeting price during early trading on Friday.

Back Where We Started
Brent fell to within 30 cents a barrel of its price before OPEC agreed to cut output
Source: Bloomberg

Even without that brief dip, Saudi Arabia is now earning less from its oil sales than it was before concluding a deal that was meant to kick prices up to $60 a barrel.

Losing Ground
Saudi oil revenues are lower now than before the output cuts were agreed
Source: Bloomberg
Note: Based on production volume times price Note: Change in production from Nov-16 to Apr-17 Note: Change in price from Nov-16 average to May 4th close

The rapid recovery in U.S. oil production is eroding the effectiveness of the plan, as I have argued. That erosion was compounded last week by news that Libya -- one of two members exempt from the arrangement -- had restored output from two of its biggest fields, taking production to the highest level since December 2014. Nigeria, the other member spared cuts, plans to restore exports from its Forcados terminal next month, potentially adding another 200,000 barrels a day to supply.

While the recovery in both countries remains fragile, it could nevertheless not have come at a worse time for the rest of OPEC.

Oil supply is still expected to lag demand by a healthy margin in the second half of the year, resulting in a significant reduction in the excess inventory -- as long as the cuts are extended and compliance remains good. At least, that is what the forecasts tell us.

The International Energy Agency sees inventories falling at a rate of around 1 million barrels a day this quarter, assuming OPEC maintains production at its current level. And the drawdown should accelerate in coming quarters. But there are warning bells ringing in the back of my head.

I am worried that they are overestimating the strength of global oil demand. My colleague Liam Denning wrote on Thursday about headwinds to demand growth in the U.S. and there are concerns elsewhere, too. India, Russia and Brazil all saw weaker-than-expected oil demand growth in the first quarter of 2017, according to the IEA, leading the agency to cut its estimate for the year-on-year increase to 1.1 million barrels a day for the period, from a forecast in January for a 1.5 million gain.

But here's the rub. There's been no impact on the IEA's outlook for annual average growth for the year, which is still 1.3 million barrels a day. To achieve this, the agency is now building in a pickup in demand growth in its projections for future quarters.

Pushing Oil Growth Back
IEA sees stronger demand growth later in the year offsetting a weaker first quarter
Sources: IEA, Bloomberg

I'm skeptical that this surge will happen. The headwinds are too great. Furthermore, I'm wary of an approach to forecasting that allows the cut from one quarter's projections to be transferred to the rest of the year, leaving the outlook for the full 12 months unchanged. That the producer group is already less optimistic about demand than the IEA adds to the grounds for skepticism. 

If I'm right, then the rebalancing that OPEC is counting on to lift prices will be severely curtailed.

So oil ministers face a difficult choice when they meet on May 25. Simply extending the current deal for production cuts to the end of the year and hoping to carry their non-OPEC pals along with them still looks the likeliest outcome. There seems to be no discussion of making deeper cuts, but perhaps there should be.

It's easy to understand OPEC's reluctance. The current deal took the best part of a year to cobble together. Compliance will be difficult to maintain in the coming months, now that there's no longer a need to perform maintenance that in past months has restricted output. Deepening the cuts would almost certainly see compliance fall, eroding confidence in the group's ability to control supply.

But if demand growth falls short of expectations, deeper cuts will be needed to drain the excess. Saudi Arabia and its partners are right back where they started in 2014 -- sacrificing market share to prop up higher cost producers.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

  1. On a simple production volume times price basis, excluding the effects of production costs and subsidized domestic sales.

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