Oil Jumps Most in Nine Months After OPEC Agrees to Output Cuts, But Will It Work?

opec-production-cut-announcementOil soared as much as 10% after OPEC approved the first supply cuts in eight years in an effort to ease a record glut and stabilise global markets, but how effective will the proposed cuts be in raising oil prices?

Defying numerous skeptics, yesterday’s historic OPEC decision to cut production, a first since 2009, marks a clear turning point in cartel, and especially Saudi Arabian, politics: individual country quotas have been allocated to all members, a third-party production verification process has been established, and the world’s largest crude oil producer Russia has committed to freeze production. At least, that’s what the deal looks like on paper.

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Saudi Arabia will cut output by 486,000 barrels a day from October to 10.058 million, according to an OPEC press release. Iraq, the group’s second-largest producer, agreed to cut production by 210,000 barrels a day. The country previously pushed for special consideration, citing the urgency of its offensive against Islamic State. Indonesia, which is a net importer, asked to have its membership suspended and isn’t party to the reductions.

OPEC plans to hold talks with non-OPEC producers on 9 December in Doha. Russia will cut production by as much as 300,000 barrels a day during the first half of 2017, the nation’s Energy Minister Alexander Novak told reporters in Moscow.

The ultimate goal of the OPEC production cut is to normalise excess inventory levels but not to target outright high prices, as that would prompt a surge of shale production. As the Nigerian oil minister Kachikwu admitted yesterday in Vienna, OPEC sees $60 a barrel as the “perfect” price for oil as at this price “it would not bring too much shale oil.

OPEC is hoping for higher prices, but not too high: anything above $55 defeats the purpose of yesterday’s deal. This is the first risk, because should the latent short interest in the future trading community continue its panicked covering, there is a distinct possibility oil may spike above $55 merely on technicals, precipitating a much faster than expected arrival of shale oil. To be sure, US production has been rising for 6 of the past 7 weeks as is, however a spike in price will accelerate it notably.
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Goldman’s scenarios for US oil production under various annual oil prices (5% lower reinvestment rate at $45 barrel)

Another key risk to emerge to the deal, as revealed in a statement issued late yesterday by Mexican oil company Pemex, which according to Bloomberg said it isn’t planning further output cuts in 2017, in stark refutation of a comment by the above mentioned Nigerian oil minister that Mexico would cut production by 150,000 barrel a day after the OPEC deal.

There is also a further risk of non-OPEC compliance. While Russia is expected to cut production by 300,000 barrels a day production, Russia’s track record in participating in OPEC production cuts is mixed. It complied well in 1998 to the two proposed cuts but instead increased production in April 1999 and January 2002. As a result, Goldman’s base case remains that Russian crude oil production will be flat.

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Looking at the last 17 production cuts (1982-2009), observed production cuts have typically come in at 60% of the announced cuts, as measured by the change in secondary source production vs. the decline announced as calculated by the difference between pre-cut production levels and the announced quota levels. Assuming the historical 60% compliance by OPEC members means the cut declines to just over 700,000 barrels from what are already record production levels.

In summary, OPEC has managed to send the price of oil surging off all time lows hit in early 2016 even as OPEC output has reached record highs, and the just concluded deal may end up eliminating just a small fraction of this excess supply. There is also risk that demand – most notably out of China – will continue to decline, delaying the so-called market equilibrium even assuming full OPEC and non-OPEC compliance. And, courtesy of Modi’s ridiculous “demonetisation” attempt, India’s economic outlook is suddenly in jeopardy: should Indian oil import demand decline as a result, OPEC will have to double its daily production cuts just to catch up to the drop in global demand.

In any case, it will take at least 3-4 months – some time in February – before the world has a sense of how OPEC is implementing and supervising its own production cuts, even as non-compliant non-OPEC members, especially shale, scramble to steal OPEC’s market share. Perhaps the best forecast at this point is that the price of oil will remain rangebound between $45 and $55. Below that and more jawboning will emerge; above it and concerns about shale output will dominate.

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