Oil Weekly: OPEC Preview – Further Production Cuts Unlikely

Summary

• OPEC+ holds its policy meeting this weekend in Vienna.
• ‘Voluntary cuts’ announced by OPEC in April came into effect last month. Further cuts seem unlikely given OPEC is already underproducing relative to the existing quota and forecasting an H2 supply deficit.
• We find that oil prices tend to fall in the month before an OPEC announcement to cut production.

Market Implication

• Given the bearish market positioning, and OPEC’s probable focus on compliance with a chance of making existing cuts official, we remain bullish going into the OPEC+ meeting.  

OPEC Members Indicate Further Cuts Are Unlikely

OPEC+ meets in Vienna this weekend to discuss changes to existing policy. This comes amid a backdrop of falling oil prices despite the announcement of further ‘voluntary’ cuts on 2 April, which came into effect last month.

OPEC stated at the time that the 1.6mn b/d of cuts were ‘precautionary’ following the negative market sentiment from the US banking crisis. We noted that the actual level of cuts was more likely to be around 0.8mn b/d because several countries were struggling to meet their existing quota due to challenges with oil production (Chart 1). Examples include Nigeria, Angola, and Iraq, whose total production was almost 1mn b/d below the original quota agreed in October 2022.

Since the announcement, OPEC has increased its forecast of global oil demand this year in its monthly oil market report (MOMR). This means the oil market is likely to be undersupplied in H2, particularly in Q4 (Chart 2).

Despite these upward revisions, the oil price has struggled to hold gains and, at $74.64 on Brent, is now down 6.5% since the end of March.

According to the IMF, an oil price below $81 per barrel is below Saudi Arabia’s fiscal breakeven, current prices would result in a budget deficit because of its vast internal investment projects. Also, at the current price, US shale producers are also unlikely to increase investment to increase production.

As is usual before an OPEC+ meeting, members have made various comments on existing dynamics. Here are the key ones:

• Saudi Arabia’s Energy Minister Prince Abdulaziz bin Salman: ‘Speculators, like in any market they are there to stay, I keep advising them that they will be ouching, they did ouch in April, I don’t have to show my cards I’m not a poker player… but I would just tell them watch out’.

• Russian Deputy Prime Minister Alexander Novak: ‘I don’t think that there will be any new steps, because just a month ago certain decisions were made regarding the voluntary reduction of oil production by some countries due to the fact that we saw the slow pace of global economic recovery.’

• Iraq oil minister Hayan Abdel-Ghani: ‘At the next meeting, which will be held on the 3rd and 4th (of June), there will be no additional reduction, and as for Iraq, we cannot reduce further’.

• United Arab Emirates Energy Minister Suhail al-Mazrouei: ‘I do not see a requirement for a meeting. The market is balanced’.

What Are OPEC’s Options?

Given existing conditions, OPEC’s choices are likely to be limited this weekend. Given existing voluntary cuts have just come into effect, and coupled with forecasts of supply deficits later this year, further production cuts are unlikely.

As stated, OPEC’s capacity to cut further is also limited. Very few countries can do so due to underproduction Pand the risk to oil-based revenues and market share (Chart 3).

One creative option could be to immediately cut production further for three months before re-evaluating. However, Saudi Arabia would likely bear the sole brunt of such an action while forgoing market share. Further, if OPEC forecasts hold, production increases would become more likely in Q4 this year. Therefore, we see an immediate production cut as very unlikely.

Another option for OPEC is to wait and see how things develop while increasing the hawkish rhetoric. The market may view constructively a warningfor potential cuts later this year should the supply deficit not materialise and an emphasis on compliance with the existing quota. This option seems most likely.

Finally, OPEC+ could also choose to make the existing voluntary cuts official. This would have three benefits. First, it would extend the duration of the voluntary cuts which currently expire at yearend. Second, it would encourage compliance. And finally, it would also require further cuts from the smaller members of OPEC+ who did not announce ‘voluntary cuts’ in April, although this benefit is marginal. We also see this option as plausible.

However, we think this year’s oil price will be determined by demand more than supply, particularly progress on Chinese oil demand and the evolution of the business cycle in the OECD.

How Would Further Cuts Impact the Oil Price?

Since 1998, there have been 24 instances where OPEC decided to cut supply (Table 1).

After the initial bounce, oil prices tend to be 1% lower one month after the announcement while rising 7% after three months and beyond. Historically, most cuts have been announced during economic slowdowns, which impacts the performance around the cut.

The decline in the oil price over the last six months would be consistent with further cuts.  But as mentioned, we think this is unlikely as the ‘voluntary cuts’ announced in April were proactive rather than reactive to an existing slowdown. A more proactive OPEC is also a more consistent theme since OPEC+ returned to market management in 2016.

Viresh Kanabar has worked in the UK financial services industry for over 8 years including in Consulting and Investment Risk. Most recently he launched The Macro Journal Substack where he puts out regular in-depth reports covering all areas of global macro.

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)