The good, bad sides of OPEC production cut

OPEC and non-OPEC members secured a nine-month extension of their deal, pushing the combined 1.8 million barrels per day in reductions through to the first quarter of 2018.

The  decision which was arrived at on Thursday last week  saw Nigeria and Libya were once again exempted from the cut due to domestic challenges already limiting the countries from producing to maximum level.

The cohesion among the disparate members was notable, although the markets, hoping for a bullish surprise, were less than impressed. After hinting at deeper cuts or perhaps an extension through the middle of 2018, oil traders were left disappointed.

There is evidence that hedge funds and other money managers built up a bullish position ahead of the meeting on the off chance that OPEC would surprise the market with more aggressive action. Once that was off the table, there was a selloff in crude positions. OPEC officials shrugged off the price drop, arguing that they can’t be concerned with daily price movements.

OPEC is confident that the nine-month extension will drain inventories back to average levels by the end of the compliance period. However, some analysts have raised the prospect of a renewed glut once the deal expires. If that were to happen, OPEC might find itself in a position of having to extend the cuts indefinitely.

Obviously, it does not want to do that. When asked about an “exit strategy,” Saudi energy minister Khalid al-Falih said that they did not have one, but that they would work on coming up with a plan over the next nine months.

The compliance rate from within OPEC has been very strong, save for Iraq. Non-OPEC cuts were less impressive over the initial six-month period. Nevertheless, the display of unity in Vienna on Thursday is a sea change from the past, and the understanding between Saudi and Russian officials in particular is important. However, compliance will be much more difficult going forward, with more members achieving higher levels of production capacity. Historically, such alliances to restrain output have proven to move oil prices in the short-run, but “they eventually fall apart,” Robert McNally, president of energy consultancy the Rapidan Group, told the Wall Street Journal.

One of the principle motivations for Saudi Arabia to keep the production cuts going is to boost the valuation of Saudi Aramco when it stages an IPO next year. The Saudi government needs higher oil prices in 2018 in order to maximize the sale of Aramco. Saudi officials allege that the company is worth some $2 trillion, although others dispute that figure. Nevertheless, the timing of the Aramco IPO ensures that Saudi Arabia will do “whatever it takes” to keep oil prices afloat.

Iraq is considering a hedging program to ensure it has predictability regarding oil revenues for next year. The head of Iraq’s state-owned oil marketing company said that the country is considering a plan to hedge as much as a quarter of its production. That move is likened to the strategy pursued by Mexico, which routinely locks in large volumes of crude sales a year ahead. The tricky thing about this size of a hedge is that it can actually influence futures prices. At this point, Iraq says it is only in the early stages of such a plan.

Olusola Bello