Oil price rally has industry speculating on OPEC's exit strategy on production limit

When OPEC decided to limit how much oil its member countries would produce, prices in North America were around $40 US a barrel and the industry was struggling mightily. On thatday in late2016 when the cartel announced its production cut, prices soared around the world.

Fast forward to today and OPEC is holding to its production cap and member countries have showed discipline in obeying their limits.

The global oil sector is in a much more optimistic place. With the market recovery underway, many in the industry are now wondering when OPEC will end its production cut and what the consequences will be. If OPEC countries start turning on the taps, will prices fall as much as they surged when the limits were announced?

Both Russia and the Saudis having both signalled a strong commitment to defending $60 [US per barrel]- Robert Johnston, Eurasia Group

Officially, OPEC says the cuts will last until the end of this year, but the cartel gave itself flexibility by saying it would review the plan at its upcoming June meeting.

Conditions are ripe for OPEC to say enough is enough, there's no longer a need to inflate prices. Not only didglobal prices touch$70 US a barrel last month for the first time in three years, but the oil glut that led to the 2014 price collapseis largely gone. Demand is increasing and storage levels are dropping significantly.

"The oil market is clearly tightening," said a recent report from the International Energy Agency, pointing to three straight quarters in 2017 when "crude stocks fell by an average of 630,000 barrels per day; such a threesome has happened rarely in modern history."

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Bye-bye cap

Amongthose who think the conditions are right for the cartel to abandon its production limitis Martin King, a commodities analyst with GMP FirstEnergy in Calgary.

"The reason I say that is because demand growth in 2018 is looking like it will be very, very strong, so I think OPEC will ease supplies back into the market in the second half of the year to meet that demand growth," he said.

"All the demand data I keep seeing manufacturing activity, Europe, the U.S., Asia demand is going gangbusters right now. Economic activity in general is doing very well globally."

As prices have risen in the last year, production has jumped in non-OPEC countries such as Canada and the United States. In fact, U.S. crude oil production is set to increase by more than 1.2 million barrels per day in 2018 compared to 2017, which is equivalent to how much OPEC cut production when it announced its limit in 2016. Shale oil production is leading the U.S. oil growth as companies using fracking technology in certain basins in Texas, North Dakota and other states.

As OPEC countries see production rise in North America in step with climbing prices, they may question whether it's worth continuing to show restraint.

"For the Saudis, given their low cost structure, additional barrels at anywhere near these prices must surely be tempting in terms of additions to government revenues, and would be aimed at thwarting other higher-cost shale producers taking market share," wrote CIBC economists in a report on oil prices this week.

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There are numerous factors that impact oil prices, but a decision by OPEC looms large because of how much oil could come potentially flood the market and how quickly. This week, Iran's oil minister said his country was ready to ramp up production if the cartel scraps output limits by at least 100,000 barrels per day within "five or six days."

Keeping prices up

It's not in the interest of OPEC to uncontrollably boost production and risk having oil prices fall, especially considering how long its taken for prices to recover from the 2014 collapse.

"Both Russia and the Saudis having both signalled a strong commitment to defending $60," saidRobert Johnston, the CEO of TheEurasiaGroup, during a speech in Calgary last month."It would take a lot to break through that and I don't think U.S. shale, even expectingthe rig count to go up, I don't think the shale response will be enough to really turn that back to a $50 price."

OPEC decided in 2014 to turn on the taps and let its member countries pump oil at will until introducing the limits in 2016. Experts say the cartel likely won't return to those free-flowing days,

"What's going to happen is OPEC will still have its hand on the steering wheel. They will continue to manage supply. All they are going to say is that inventories have gone down to the target we set so we will raise our production target,"saidMichael Wittner, the head of oil research with Socit Gnrale, in a phoneinterview from New York.

He expects production to increase slowly as the cartel shows the market that it will continue to control supply and show some level of production restraint.

"They will go back to what OPEC has historically done, which is to have a target and manage supply," said Wittner."It's not that prices will collapse, but the opposite. It will eliminate price being out of control to the upside."

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