Will OPEC production cut lead to an increase in crude prices?

The Organization of the Petroleum Exporting Countries (OPEC) is among the world’s most powerful cartels. It controls more than one-third of the global crude oil supply. Production cuts or embargoes by OPEC have led to huge increase in petroleum prices in the past, which have been termed oil shocks. The first oil shock in 1973 resulted in oil prices increasing by over 400%. The one in 1979 caused oil prices to double. However, a look at recent trends in the oil economy suggests that OPEC might be losing its historical dominance.

In November 2016, OPEC countries, along with Russia, decided to reduce their crude oil production by around 1.5 million barrels per day (mbd). This came in the backdrop of a 70% fall pricin crude es since early 2014. Crude prices went up by 35% between November 2016 and November 2017. OPEC started increasing its crude production from June 2018 on. However, this did not prevent an oil price rally. Crude prices increased by 18% from the last week of June till early October.

On 11 November, Saudi Arabia, the biggest oil producer in OPEC, announced that it would reduce its daily oil output by 500,000 barrels per day. It also asked other OPEC and non-OPEC producers to reduce their oil output by 1 mbd. However, this did not prevent the ongoing fall in oil prices. Brent crude prices fell by 14% between this announcement and 30 November. What explains this apparent mismatch between OPEC behaviour and oil prices?

Chart: OPEC, non-OPEC production and Brent crude prices

Two reasons can be offered. Non-OPEC members have a considerably higher share of total crude production now. According to US Energy Information Administration (EIA) data, share of non-OPEC producers in world oil production was 46% in 1973. This has increased to 57% in 2018. Shale oil production in the US is the biggest contributor to the rising share of the non-OPEC block in global crude production.

Also, it seems that factors other than OPEC production are playing a bigger role in determining oil prices. A strong economic recovery in advanced countries contributed to tightening in oil prices earlier this year. The US government announced a re-imposition of sanctions on Iran, which would have led to a cut in Iranian oil exports. This provided further tailwinds to oil prices.

Both these factors changed subsequently. The International Monetary Fund (IMF) downgraded its global economic growth outlook in mid-October. The US announced exemptions for countries such as India, China etc., allowing them to import crude oil from Iran. Oil prices have reversed their rising trend since mid-October. Crude prices have fallen more than 30% in the last tow months. Crude oil posted its first major gain in a month on 3rd December after the US and China agreed to a temporary truce in their ongoing trade war, reducing the downside risk for the global economy.

The question is whether a production cut by the OPEC in the wake of truce between the world’s two biggest economies will lead to a rise in prices? Deepak Mahurkar, partner and leader at PricewaterhouseCoopers (PwC), said that while OPEC members cut production with the intent of increasing oil prices, many other factors contribute to the final outcome and so only time will tell how the production cuts help the OPEC’s cause. Madan Sabnavis, chief economist at Care Ratings, said that while OPEC’s production cuts will definitely lead to a rise in oil prices, the extent will depend on the combination of demand from non-US consumers, especially China, inventories and domestic demand in the US, given the onset of winter, and supply from non-OPEC nations. While we can expect prices to increase, it will definitely not cross $70/barrel and a hike of $3-5/barrel is more likely, Sabnavis added. Brent Crude price was $61.97/barrel at 6pm on Wednesday.

First Published: Dec 07, 2018 22:15 IST