What the new OPEC deal really means

The world’s largest oil exporters have agreed to cut output for the first time in eight years to erode a global supply overhang that has persisted for two years and halved the value of a barrel of crude.

The Organization of the Petroleum Exporting Countries (OPEC) confirmed its decision to implement a new production target of 32.5 MMb/d effective January 1, 2017 for six months to accelerate the ongoing drawdown of the stock overhang and bring the oil market rebalancing forward. The reduction agreed during the OPEC 171st meeting in Vienna, will cut output by some 1.2 MMb/d, from the current 33.64 MMb/d.

Commodity watchers also believe the deal will set up a long-awaited balance between oil supply and demand in the first half of next year.

The oil cartel also agreed at the conference to establish a High-level Monitoring Committee, consisting of oil ministers, and assisted by the OPEC secretariat, to monitor the implementation of the agreement in addition to institutionalizing a framework for cooperation between OPEC and non-OPEC producing countries on a regular and sustainable basis.

Saudi Arabia, OPEC’s largest producer, has agreed to bear the lion’s share of the cuts, but most member countries, including Iraq, which had initially refused to freeze its output, will limit their production.

Iran, Libya and Nigeria were all given special dispensation not to join in with the reduction, as the three are still fighting to boost their exports and regain market share lost to international sanctions, or civil unrest and violence.

Mohammed al-Sada, Energy Minister for Qatar, and current OPEC President, said key non-OPEC members had agreed to cuts of 600,000 bpd, of which Russia had committed to 300,000 bpd.

OPEC members on December 9 will meet its non-cartel counterparts to discuss their contribution to the effort to limit output. Losing market share to Russia and non-OPEC producers in general has always been a major fear for the OPEC producers. Even though Russia’s support for the deal was encouraging for the market, there is no evidence that Russia has actually supported any OPEC decisions to cut production in the past beyond official statements.

Higher prices, a double-edged sword

Most OPEC producers need higher oil prices to solve their own budget woes and the production cut is geared towards stimulating higher prices. However, that could be a double-edge sword as those higher prices could lead to a surge in production by US shale producers. And if those producers exacerbate the supply glut that has plagued the market, it will be much more difficult to reach another deal when this one expires in six months.

Already, oil rigs began popping up in US oil fields when prices approached $50 a barrel and analysts believe high-cost producers outside OPEC will further ramp up production if crude prices rise above $55 a barrel.

That includes US shale drillers, which have built a backlog of partially completed wells in anticipation of a price recovery. Once prices rise, they could switch on that production-in-waiting.

Saudi still the big winner

The production cut deal means the Saudi Arabia will reduce output by 486,000 barrels a day, to 10.05 million barrels a day. But this number is only 123,000 barrels below its 2015 average daily production and, indeed, higher than in previous years. This means the Kingdom’s output is remaining at its sustainable production level of around 10 mbpd which is nearly one-third of overall OPEC output.

For Iran, losing its status of second-largest OPEC producer to Iraq was, in an understatement, not an easy adjustment for the country. Iranian officials insisted in recent OPEC gatherings that the country would neither freeze nor cut its production, given the hit output has taken in the last four years. And OPEC obliged. The oil cartel agreed to use the country’s production of 3.97mbd in the final quarter of 2015, the highest level in 16 years, as the base for calculating any cuts.

The deal means that Saudi Arabia will cut the most, about 40 percent of the total with Iraq and Russia adjusting down by 210,000 bpd and 300,000 bpd, respectively.

$72 per barrel touted

Forecasts from oil and gas analysts at investment bank Jefferies project that the price of Brent crude oil will hit $58 per barrel in 2017 and $72 per barrel in 2018 following OPEC’s pledge to cut production.

The predictions anticipate a slower price climb than the one forecasted by David Pursell, Tudor Pickering Holt & Co. managing director, after hearing that OPEC had agreed to curb output for the first time since 2008. Pursell told investors that the production cut could get inventories down to normal levels by next summer, which would grow confidence that oil could price at $75 per barrel in 2017.

Oil prices rallied for their best week in at least five years, steadying above $51 a barrel, following OPEC’s decision to cut crude output to rein in a global glut that has weighed on prices for more than two years.

Front-month Brent crude futures ended the session up at $54.46 a barrel, up 52 cents, 0.96 percent. The contract rose more than 15 percent for the week, its biggest gain since early 2009. US crude settled at $51.68 per barrel, up 62 cents or 1.21 percent and notched its biggest weekly gain since early 2011, with a rise of 12 percent.

Concern over cheats mount

Saudi Arabia faces the unenviable tasks of policing cartel members and keeping crude prices within a range that will relieve pressure on oil-producing countries’ economies, but which will dissuade non-OPEC producers from increasing output.

Skeptics have warned that OPEC members are notorious cheaters and may not stick to quotas agreed. Ali al-Naimi, former Saudi Arabia Oil Minister, is one of the skeptics.

“The only tool they have is to constrain production,” al-Naimi said of OPEC at an event in Washington, D.C. “The unfortunate part is we tend to cheat”, al-Naimi said adding that he was not opposed to production cuts in 2014, as long as everyone participated.

He also expressed skepticism that Russia, considered a wildcard during talks, would follow through on its promise to reduce output. “Will Russia cut 300,000?” he said. “I don’t know. In the past, they didn’t.”

The deal represents a departure from the pump-at-will policy promoted by al-Naimi when he was oil minister and OPEC adopted that policy in 2014.

FRANK UZUEGBUNAM