Why OPEC Production Cuts Will Fail

OPEC cut production and oil surged. We explain why the cartel will be unsuccessful in going back to its old ways of price manipulation.

sumit
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Senior ETF Analyst
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Reviewed by: Sumit Roy
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Edited by: Sumit Roy

It was almost exactly two years ago that OPEC, when confronted by tanking oil prices, famously decided to hold the line on production, ushering in a period in which the cartel would protect market share at the expense of prices.

That move―orchestrated by Saudi Arabia―was a signal to the world that OPEC was powerless to prevent the collapse in oil prices that was spurred by the shale revolution in the United States.

The oil market buckled, with prices falling more than 50% in the months following the policy shift. Headlines proclaimed the "end of OPEC," and the world looked forward to a new paradigm of permanently lower oil prices.

Today OPEC pushed back emphatically against that narrative. Led once again by Saudi Arabia, the Organization of the Petroleum Exporting Countries agreed to slash production by 1.2 million barrels per day, the first reduction since 2008.

Oil prices surged by 9% on the news to $49/barrel. The United States Oil Fund (USO), which tracks oil futures, gained 9% also. Meanwhile, the Energy Select Sector SPDR Fund (XLE) and the SPDR S&P Oil & Gas Exploration & Production ETF (XOP), which track energy stocks, rallied 5% and 10%, respectively.

YTD WTI Oil Price

What's Changed In The Past Two Years

The immediate reaction in oil prices suggests that traders are impressed with OPEC's comeback. If anything, the cartel has proven it can still capture the attention of the market and move prices significantly―at least in the short term.

But what, if anything, has changed in the last two years to prompt OPEC to reverse course on its policy of market share maximization to now price manipulation?

Perhaps the biggest change is the trajectory of United States oil production. On Nov. 27, 2014, when OPEC made its last big policy decision, U.S. output was rapidly climbing. Output in that month was close to 9.1 million barrels per day, up more than 1 million barrels per day year-over-year. In fact, production wouldn't peak for another eight months after that, in June 2015, at around 9.6 million barrels per day.

In that environment, it made little sense for OPEC to cut production. Why prop up oil prices only to see U.S. producers continue to drill all-out, negating any reductions the cartel makes?

By stepping aside, OPEC hoped the market would reach equilibrium naturally, forcing U.S. producers to scale back their drilling activity. That's exactly what happened. Low oil prices and tighter credit conditions led U.S. oil companies to slow output dramatically. By the summer of this year, output in the country dipped as low as 8.4 million barrels per day, down 12.5% from peak levels.

 

Cuts Shouldn't Be Taken At Face Value

Emboldened by the struggles of its biggest competition, OPEC believes it can go back to acting like a cartel again, squeezing prices higher with output cuts.

According to the agreement, Saudi Arabia will take on the bulk of the cuts, accounting for 0.5 million of the 1.2 million barrel per day reduction; Iraq may account for 0.2 million barrels per day of the cut; while Iran will freeze output at presanction levels. Additionally, non-OPEC countries such as Russia may reduce their production by 600,000 barrels per day, according to sources.

Taken at face value, this agreement would be unequivocally bullish for oil prices. A combined 1.8 million barrels per day decrease in global output would push the market decisively into a deficit, leading to steady withdrawals from inventories.

The problem for OPEC is that the proposed cuts can't be taken at face value. Aside from Saudi Arabia and a few of its small Gulf allies, it's unlikely that most member countries will abide by their pledged quotas. Iraq, where output has nearly doubled in the last six years, and which needs funds to fight ISIS, is more likely to continue growing its production than cutting back.

Iraq Oil Production

Source: Bloomberg
 

Venezuela, which is facing economic calamity, likely won't shoulder its share of proposed cuts. Russia, which often promises to join OPEC in reducing production, never follows through. The list goes on. It's almost a certainty that the actual production cuts that materialize from Wednesday's agreement will end up being much less than what has been proposed.

 

US Production Comeback To Trump OPEC

The second and bigger problem for OPEC is that U.S. production is slowly rising again. For all the talk of  an OPEC comeback that will result from today's news, more important is the trajectory of output in the U.S.

Based on the latest data from the Energy Information Administration, U.S. crude production hit 8.7 million barrels per day last week, up 270,000 barrels per day from this year's lows and the highest level in almost six months.

US Oil Production

A number of indicators, including rig counts—which are up 50% from their lows—point to U.S. producers increasing their activity. That's based on oil prices rebounding from $26 in January to the high $40s more recently.

If oil spikes into the $50s, $60s or higher, U.S. output will surge, putting OPEC back into the predicament it faced two years ago. That's why, as much as OPEC wants to reassert its influence on the oil market again, it will ultimately fail.

Contact Sumit Roy at [email protected]

 

Sumit Roy is the senior ETF analyst for etf.com, where he has worked for 13 years. He creates a variety of content for the platform, including news articles, analysis pieces, videos and podcasts.

Before joining etf.com, Sumit was the managing editor and commodities analyst for Hard Assets Investor. In those roles, he was responsible for most of the operations of HAI, a website dedicated to education about commodities investing.

Though he still closely follows the commodities beat, Sumit covers a much broader assortment of topics for etf.com, with a particular focus on stock and bond exchange-traded funds.

He is the host of etf.com’s Talk ETFs, a popular video series that features weekly interviews with thought leaders in the ETF industry. Sumit is also co-host of Exchange Traded Fridays, etf.com’s weekly podcast series.

He lives in the San Francisco Bay Area, where he enjoys climbing the city’s steep hills, playing chess and snowboarding in Lake Tahoe.