Another Nine Months of Oil Production Cuts

5th July 2017

At the end of June, the last six months of oil production cuts came to an end. However at the recent OPEC meeting, the cuts were extended for a further nine months. Our Managing Director Barry Newton explains what this means and how the decision is likely to effect the price of oil.

As the year moves swiftly on, the latest OPEC meeting came and went as usual at the end of May. The meeting is a chance for the representatives of the OPEC nations to get together and plot, or should I say decide, the future of the oil industry. Joining the OPEC representatives this year were members of the non-OPEC fraternity who had been taking part in the first round of production cuts agreed to last November.

The Last Six Months

Before taking a look at the outcome and consequences of the latest meeting, however, it seems a good idea to review exactly where we were prior to the meeting. All parties, OPEC and non-OPEC, agreed last year to roll back production of about 1.8 million barrels per day for a six-month period, which came to an end on 30 June 2017. To everyone’s surprise, it appears that the cuts have been implemented, and this has resulted in the market seeing a relatively slow rebalancing of oil production, supply and the overall inventory position.

However, it seems that the market doesn’t like slow a re-balancing, and prefers a quick action and reaction to events or announcements, which means that the longer the cuts are in place, the less effective they seem to become. The cuts did however bring about the $50 per barrel level, which was welcomed by many and saw the US oil industry take it as a sign to add rigs as if it were a game, hedging their production at high prices and drilling like their life depended on it. We are seeing similar activity, although not to the same level, in Canada.

The OPEC Meeting

As many oil market participants knew prior to the meeting this May, due to pre-announcements, Russia and Saudi Arabia agreed to extend production cuts for a further nine months, continuing to exempt Libya, Nigeria and Iran to a slightly lesser extent. For many reporters, this was seen as the safe option, and for many of us in the real world, it seemed a completely viable and understandable outcome. To put it in perspective, this was equivalent to a group of countries (that rely on oil revenues to carry on in the style that their populations expect) holding back around 800 million barrels of oil from the market.

What the OPEC and non-OPEC countries had hoped to achieve with this announcement, both in its goals and timespan, was to keep market prices higher, ensure investment in the oil and gas sector, ensure the sustainability of companies in the sector, and eliminate a lot of uncertainty and quarterly speculation from the market. OPEC and non-OPEC members now have nine more months to sit on their hands and resist the temptation to press that extra production button.

The Market’s Reaction

Reactions to OPEC meetings are usually mixed – for some, the outcome will result in great joy, for others it will turn oil into their nemesis. The effects can usually be seen in the hours following any announcement, as well as in the following weeks and months. There is often market reaction before the meeting has even started, due to good old fashioned rumours and some possible market positioning by the larger oil players.

On this occasion, we saw further cuts, good compliance and general agreement … and the market reacted by selling off by more than 5 percent. We can only imagine that the sell-off was a purely speculative move, with a lot of short covering and people selling out of long positions which had been put in place as a bet on deeper cuts. The sell-off came after the market had shown a run up ahead of the meeting, which was as unexpected and uncalled for as the sell-off afterwards.

Decreased Production, Increased Price?

It is likely that, over the coming weeks and months, we will see a continuing reduction in inventory levels and a steady rise in oil prices; many analysts are now saying that crude oil will reach $60 per barrel by the third quarter of 2017 (this would happen in an ideal world but, as we all know, we don’t operate in an ideal world – there could be price spikes and lows, which could threaten compliance to the cuts both in terms of increasing producing or making further cuts).

The best way of tracking whether the cuts are doing their job is by looking at the oil price. It must be remembered that, according to media sources, the oversupply in the market was around 500 million barrels; this is a large amount of product to take out of the market, and it is going to take some time. During the last six month of cuts, prices have recovered with occasional dips and overall, we have seen a rising market. One therefore has to assume the cuts are already working.

Cutting production is always difficult to get right: too little and markets are uninspired and stay the same or drop; too much and prices surge and oil producers are tempted to not adhere to the cuts (so end users end up paying more, which slows demand and increases stock levels, which pushes prices down again). It’s a complicated business, the oil market.

The Next Nine Months

The oil market is incredibly unpredictable, with many factors influencing pricing minute by minute: prices are particularly sensitive to the economic outlooks of China and India; In the US, the summer driving season usually causes stockpiles to decrease and prices to increase; world events move quickly and geopolitical situations can come out of the blue and have an impact on markets that nobody could have foreseen.

So it seems that we have another nine months of excitement ahead where the market will either do exactly what we think it should, or something completely different. I am confident that, if all parties adhere to the cuts agreed, inventory levels will reduce over time and prices should move higher. Ideally this will be a lovely steady increase over the next nine months … but then again, who knows?