Will OPEC Cuts Balance the Market?

July 10, 2017

Written By Tim Danze

When the Organization of Petroleum Exporting Countries (OPEC) announced on Nov. 30, 2016, it would cut crude oil production in an effort to drain record global inventories, the oil market quickly responded. Crude prices immediately shot up 9 percent from $45.24 to a high of $49.44. The agreement, which notably included cooperation from non-member Russia, called for reducing overall crude production by 1.2 million barrels per day for six months—limiting daily output to a total of 32.5 million barrels beginning in January 2017. Only two OPEC member-countries, Libya and Nigeria, are exempt from participation in the production cap.

The OPEC cuts were surprising because many of the countries in the cartel, such as Saudi Arabia, Iran and Iraq, rely on oil to fuel their economies. The fact OPEC was able to convince its members and other oil-dependent nations, like Russia, to cap production showed just how desperate these countries were to find a way to end the global supply glut keeping a lid on prices.

Since the cuts began in January, crude stockpiles have declined marginally. The problem for OPEC is that while its members have curbed the flow of oil entering the market, U.S. shale oil producers have stepped up their production. This prompted OPEC and Russia to extend the production cuts for an additional nine months to March 2018.

The day OPEC announced the extension of its cuts, crude oil prices opened at $51.25 and ended the day at $48.90. In hindsight, it appears the extension, which was not a surprise, looks to have been already priced into the market.

As I write this commentary in early June, the market is still closely watching the inventory situation. The weekly U.S. Department of Energy report for early June showed crude stocks were down by 6.4 million barrels, putting total stocks at 509.9 million barrels or about 5.7 million less than the prior year. Crude oil production in the United States was reported at 9.3 million barrels per day. The demand for gasoline and distillates has been strong, yet the price of crude is still sitting at just under $50 per barrel.

Given this data, what conclusions can we draw from the first seven months of the OPEC production cuts?

With a broad brush and in general terms, the supply of crude, gasoline and distillates has been trending lower. However, the uptick in production from U.S. shale producers and countries outside of OPEC’s agreement have kept the overall inventory picture relatively unchanged. The bottom line is the market needs more time to work this out. That’s why OPEC is hoping the extension of its cuts will give the market the time it needs to work through the excess supply.

Some speculation indicates U.S. shale crude oil producers will be unable to sustain their current production levels for the long term. If that proves true, it could help to finally bring balance to the supply and demand equation.

For the moment, prices seem unable to break free from their current trading range between $45 to $55. There was a three-month window after OPEC announced its planned cuts in November where the market rallied, but prices have remained stuck in the aforementioned range since then. In the meantime, American shale producers continue to disrupt OPEC’s plans by producing as much as they can through improved efficiencies and hedging their production forward.

It is just a matter of time before the situation changes and supplies tighten to the point where prices cross the $55-per-barrel threshold. As it’s been said, time heals all wounds, and this cyclical energy business will again see supplies tighten and prices rise. We just don’t know how long it will be before it happens.