OPEC Blinked ‑ A Strategy Shift | The Perryman Group

OPEC Blinked ‑ A Strategy Shift

By: Dr. M. Ray Perryman
Published in syndication December 07, 2016

Members of the Organization of Petroleum Exporting Countries (OPEC) have agreed to cut crude oil production by 1.2 million barrels per day beginning in January. Russia announced it would cooperate and lower production by 300,000 barrels per day, and there is some chance other nations representing about 20% of global production will also join in following an upcoming meeting.

The announcement of the cuts moved markets, and oil prices jumped significantly. There have been signs that an agreement was becoming more likely, but getting a deal done is very difficult in a cartel such as OPEC. Saudi Arabia is expected to contribute about half of the cuts, with its allies contributing the rest. Some OPEC nations will continue to produce whatever they can, as will other nations.

It's the first cut in eight years, marking an important strategic change. In November 2014, OPEC announced that it would try to maintain market share by increasing production, depressing prices, and shutting down higher-cost oil producers such as the US shale segment. Crude oil prices, already off $100+ peaks due to oversupply, began to seriously tumble. West Texas Intermediate Crude spot prices were ultimately down from about $77 per barrel in November to less than $30 per barrel just a few months later. Drilling in US shales dropped sharply, and production has fallen off. However, the oil-dependent OPEC economies have also been harmed, and revenue to OPEC nations has also fallen as a result of lower prices.

Gulf nations have been running huge budget deficits after years of surpluses and increasing cash and assets. Many countries in the region derive the majority of revenue from energy, and pressure has been mounting for a change. For example, in October, Saudi Arabia held its first (ever) international bond sale as part of an effort to shore up its economy and government, with subsequent offerings which could raise more than $100 billion through 2020. Two years of low pricing has taken its toll on Saudi Arabia and other OPEC members, resulting in the current agreement.

Some analysts have taken the position that the announcement isn't really a game changer because it will be difficult to actually curtail overall production. Not only do OPEC members have an incentive to cheat (and a long and distinguished history of doing so), but also non-OPEC countries can ramp up production. The challenge is increased by the current oversupply and the fact that some OPEC nations have increased production to record levels in advance of the coming cuts.

Even if the first round of OPEC production cuts is overcome by increases in non-OPEC nations, the fact that OPEC is shifting its strategy from driving down prices to run producers out of the business to supporting crude oil prices is significant. We can expect markets to begin to normalize and drilling activity to continue to trend upward to some extent here in the United States. It is also likely that OPEC will consider additional cuts if this round is insufficient to push prices into the desired range.

The other aspect of normalizing markets is the demand side of the equation. Although the rate of increase in crude oil consumption in China has slowed, demand in India has been growing fairly rapidly. The US Energy Information Administration notes that "global economic data have been more positive than previous expectations, and increases in oil demand growth could help to support prices in the coming quarters." Recent data for manufacturing in the United States, Eurozone, China, and India also indicates potential for expansion.

Ultimately, oil prices are determined by many factors, not the least of which is the expectation of dramatic long-term growth in global demand. However, OPEC moving away from its objective of pushing down prices is one of the most important. It will take some time to work through the oversupply, and as prices trend upward, there will be incentives to ramp up production in non-OPEC areas. Even so, we are clearly closer to market normalization and a notable uptick in oil prices, which is good news for oil producers and the Texas economy.