Sunday, 19 February 2017

OPEC cuts - a short-term gain for a long-term pain?

OPEC’s strategy has worked so far, but could end up being self-defeating.

OPEC surprised markets on 30 November 2016 by agreeing to cut oil production in an attempt to support prices. The cuts were meant to reduce OPEC’s production by roughly one million barrels per day (mb/d), effective from 1 January 2017. Data released in the last few days provide the first test about whether the cuts have been successfully implemented. The bottom line is that: compliance has been high helping prices to move up; the overall movement was beneficial for the finances of OPEC members; but could prove to be short lived as it gives a lifeline to US shale producers, who are likely to ramp up production and depress prices. Below I elaborate on these points.

1. OPEC members have complied with the agreed cuts. The latest data show that production fell to 32.1 mb/d, lower than the 32.5 mb/d ceiling that had been agreed on. Every single country reduced its production compared to October 2016 levels (see chart). Some have made substantial reductions as in the case of Saudi Arabia, which lowered its production by 598 kb/d.

2. The cuts have moved oil prices to a new and higher range. While oil prices hovered around $45 per barrel before the cuts, they have been fluctuating around $55 per barrel since the agreement. This represents an increase of about 22%.

3. The cuts have so far benefited OPEC finances as the gain in prices more than offset lower production. The rise in prices has far exceeded the cuts in production. For example, Saudi oil output has fallen by 6% since last October, while prices have risen by 22%. If current prices and production were to be sustained for the whole year, Saudi oil revenues would be higher by around $27bn compared to what would have happened without the deal.

4. But higher oil prices may not be sustained as US shale oil could make a comeback. Higher oil prices are making US shale oil profitable again. US production rose in December after several months of continuous decline. The International Energy Agency is reporting increased investment in US shale oil, implying more supply to come in 2017. Higher US supply would lead to lower prices, reversing the gains made by OPEC cuts.

In conclusion, OPEC successful implementation of production cuts has pushed prices higher and benefited the revenues of its members. But the strategy could be self-defeating as it is giving US shale oil producers a lifeline to increase their production and depress prices again. If this does happen, then OPEC would either be required to support prices by making further cuts or make a U-turn on its strategy.