OPEC finally agrees to a production cut; but what does that mean?

The OPEC meeting on November 30th at Vienna actually turned out to be highly productive for the OPEC. The cartel which accounts for nearly a third of global oil production has decided to cut production of crude oil by nearly 1.2 million barrels per day (bpd). That will effectively take the total OPEC production down to 32.5 million bpd. While this will definitely boost the price of oil in the short run, the question is how significant is this cut in production.

Back in 2014, when the price of Brent Crude was quoting at above $110/bbl, the total OPEC production was at 29.5 million bpd. Over the last 2 years, a glut of supply from US shale, peak capacity operation by OPEC members as well as an unprecedented stockpile of oil globally resulted in a sharp crack in oil prices. Between November 2014 and March 2016, the price of Brent crude fell from $114/bbl to a low of $23/bbl losing nearly 80% of its value along the way. The question, therefore, is that since the OPEC production after the supply cut will still be 3 million bpd higher than the 2014 figure, how significant will it be?

How the OPEC supply cut will be shared…

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There are some interesting trends in the way the OPEC members have shared the production cut. It is hardly surprising that Saudi Arabia which produces over 10 million bpd has taken the biggest cut of nearly ½ million barrels per day. Interestingly, Iran has been allowed to actually increase its daily production to restore parity with the pre-sanction levels. Iran lost access to the global crude oil markets over the last 4 years due to US imposed sanctions. Also, there is no production cut that has been decided for Libya and Nigeria. Both these African nations have been in the midst of political and ethnic strife which has seriously impacted their oil production capacity. Like Iran; Libya and Nigeria may get an exemption from production cuts considering their unique positioning. The rest of the OPEC members will have to contribute to supply cuts…

Understanding redistribution of Indonesian quota…

One of the very significant announcements in this OPEC meet of November 30th was that the OPEC has decided to suspend the membership of Indonesia. It would be interesting to go back in history to understand the role of Indonesia. When Indonesia’s OPEC membership expired in 2008, Indonesia chose not to renew its membership as it had become a net importer of oil by then. The Indonesian economy with its growing young population and domestic consumption story had emerged as a strong consumption and demand play like India and China. Since the OPEC was a cartel for net oil exporters, Indonesia did not renew its membership as it had become a net importer of oil by then. What the OPEC has promised is that Indonesia’s quota of 700,000 bpd will be re-distributed among its other members. If you adjust this 700,000 bpd of Indonesian quota from the 1.2 million bpd of production cut, the net reduction in supply will only be ½ million bpd. In the overall scheme of things, this may not be really significant to cause a sharp upsurge in oil prices.

Key takeaways for oil prices going ahead…

The OPEC meet may be a good start, but the pitch may be queered by the following 6 factors. Here is a quick rundown on these factors to watch out for…

  • The actual reduction in oil supply from the OPEC will only by about 500,000 bpd after considering the additional Indonesia quota. On a daily supply of nearly 90 million bpd, that may not be too significant to impact crude oil prices meaningfully.
  • Russia could be the unknown quantity in this entire OPEC game. While Russia has agreed to cooperate on paper, it may not be too easy considering that the oil oligarchs in Russia wield considerable economic and political clout in the Putin government.
  • What the OPEC and Russia will be watching for is the US reaction to crude prices. If the price of Brent crude climbs well beyond $50/bbl, then a lot many idle shale wells in the US may actually become viable. That will not be a comforting scenario for the Russia or the OPEC.
  • Trump has already promised to invest heavily in prospecting for oil across the length and breadth of the US. If the OPEC cuts production and the US enters to fill the gap, then the OPEC may end up subsidising the revival of US shale. That defeats the basic purpose.
  • Economic stability of OPEC member countries will also be critical. Most OPEC members are already running huge budget and fiscal deficits. Push comes to shove; most OPEC members may not have the incentive to honour their commitments to oil quotas.
  • The real variable to watch out for will be the global oil stockpiles. Currently, the oil stockpile is estimated to be nearly 8 billion barrels. Of this, nearly 4 billion barrels are in the form of Strategic Petroleum Reserves (SPRs) while another 2 billion barrels are in the form of commercial oil holdings. The balance 2 billion barrels represent oil at sea. The world is already running out of oil storage space and winding down reserves may be the only option. That is not great news for oil prices.

The OPEC today constitutes just about 1/3rd of the global oil supply and hence may not be as significant a player as it was 2-3 decades ago. Setting quotas may be the easier part of the job. Monitoring adherence, enforcing discipline among members and influencing prices may be the harder part!

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