The key for OPEC in balancing the oil market is to flip the futures curve.

Goldman Sachs warned that until the oil futures market moves decidedly into a state of backwardation, OPEC could struggle to significantly drain inventories. As it stands, the market contango – a situation in which near-term oil futures trade at a discount to deliveries six or twelve months out – allow shale drillers to hedge their future production and lock in higher prices for delivery at a later date. That provides shale companies with the certainty of future revenues, allowing them to move forward with drilling today. The end result is an uptick in supply in the near-term, which ultimately delays the end goal of rebalancing.

The objective for OPEC, then, is to move the market into a state of backwardation – the opposite of contango – which would mean front-month oil contracts trade at a premium to oil futures six months or twelve months away. In that scenario, it becomes disadvantageous to store oil since a trader would not only have to pay the cost of storage, but would also realize a lower price in the future.

Backwardation, as a result, induces steeper declines in inventories. Moreover, without the ability to hedge, shale drillers might not have the nerve, or perhaps even the ability, to ratchet up drilling. "OPEC is too big to hedge, so they get the lower spot prices. What they're after is to flip that curve," Goldman Sachs’ Jeff Currie told CNBC this week. Backwardation, then, is the key for OPEC to not only drain inventories, but also keep the U.S. shale industry at bay. Related: As Breakeven Prices Converge An Oil Price Crash Nears

That is the underlying logic behind the surprise announcement that Saudi Arabia and Russia want to extend the production cuts through the end of the first quarter of 2018. Not only will extending the cuts keep supplies off the market, but they hoped the psychological impact of the surprise announcement would alter expectations. They hoped to shock the market, which would increase the chances of a stronger move into backwardation.

It is unclear if the announcement will achieve that. For now, energy watchers like the IEA and Goldman Sachs see the extension for nine months as probably a strong enough move to drain inventories back to average levels in 2018, but probably not sooner.

In the short-term, the OPEC/Russia announcement of a nine-month extension only led to a rather modest jump in prices. Goldman’s Jeff Currie says that the extension has already been priced in. "The market has worn thin on patience." Announcements from OPEC has time and again moved oil prices over the past few years, but the rhetorical power of the Saudi energy minister on his own to move the market is waning. "If you look at what's happened since the beginning of the year, [the market has] tried to trade the OPEC production cuts, the big draws in the U.S. inventories, and it got stung once in April and again in May," he said. Only sizable and observable drawdowns in inventories will move oil prices up going forward. Related: U.S. Shale Just Won’t Die: Bankrupt Drillers Rise Again

One complicating factor for this calculation is the prospect of new U.S. shale production. Unless a strong flip into backwardation arrives, U.S. shale output is expected to continue to climb. The EIA recently revised up its forecast for U.S. oil output, which it says will jump from 8.9 million barrels per day (mb/d) in 2016 to 9.3 mb/d this year, followed by another massive increase to 10.0 mb/d in 2018.

In fact, Bloomberg suggests that some shale drilling could be delayed because of a shortage of fracking crews. While that might hinder near-term shale production, it might only push it off until next year. The shortage of frack crews “means U.S. oil production growth this year will be back-half weighted, and we may not understand the full extent of U.S. production growth until early 2018,” Joseph Triepke, founder of consulting firm Infill Thinking LLC, told Bloomberg. “This point is particularly scary if you are rooting for higher oil prices.”

Meanwhile, WTI and Brent showed weakness on Wednesday and Thursday despite two consecutive weeks of strong inventory declines. Analysts attribute the selloff to the political turmoil in the U.S., with scandal engulfing the Trump administration. The U.S. stock markets posted their worst trading day of the year as prospects for tax cuts faded amid all the political controversy. Oil sold off along with everything else.

By Nick Cunningham of Oilprice.com

More Top Reads From Oilprice.com: