OPEC Production Cuts: Analysts Doubtful on Delivery

The decision by OPEC to limit oil supply from November caused West Texas Crude (WTI) to jump more than 5% on Wednesday, but does this mark a new dawn for oil prices or a false breakout?

At the OPEC meeting in Algiers members set aside differences and agreed to a cut of 800k barrels a day to a level between 32.5m and 33.0m barrels a day of gross global production.

This represents about a 2.5% cut in oil production but caused an even higher 6% increase in oil prices, with WTI jumping from the 44s to 47.20.

Recent commentary on the matter suggests the decision was, predictably, driven by the Saudis.

The Wall Street Journal reports that Saudi energy minister Khalid al-Falih’s attention was drawn to an Organization of the Petroleum Exporting Countries’ prediction that a global glut of oil would persist well into 2017, said people familiar with the matter.

The data suggested that economic pain from low oil prices would last longer than the ministry first believed, as the Saudis fought an expensive war in Yemen and middle-class living standards eroded.

“The pressure was mounting,” a person close to the Saudi oil ministry told the WSJ. “Falih and the government realized they need to show they are not just watching their economy and others suffer.”

Some analysts are sceptical about whether oil can hold onto these gains as they see an agreement as still quite far away from implementation.

Broker Hantec’s, market analyst, Richard Perry, for example says that whilst the move was strong technically, there is still a big question mark as to how implementation will work.

“Technically the move is very strong with RSI and Stochastics confirming the move, but we still need to be wary. I do not believe that the volatility will be over now a decision has been made to cut production, as the move still needs to be implemented by individual countries and there could be some scepticism over how this will work in practice.”

On the point about implementation, Swissquote’s Arnaud Masset elaborates, arguing that OPEC’s history in this regard has not been very positive.

“Even if it (the supply cut) is good news for oil prices, this is just a pre-agreement in which OPEC members agree to trim production without actually specifying who will take the cut or how it will be divided.

“Therefore, we remain cautious concerning the effects of an actual trim in production, especially in view of the OPEC’s history of consistently failing to reach a consensus,” he remarks.

One thing which would make the rally in crude more sustainable would be the agreement of non-OPEC member and second largest oil producer in the world Russia.

Bank of America Merril Lynch’s head of research, Thomas Rhys Edwards, has said the supply cut “represents a truce in the war on oil.”

The Saudi’s reluctance to countenance an earlier cut in production was due to a desire to starve out US shale producers and was quite successful when oil prices were below $40 a barrel.

However, growing pressure from OPEC members with budgetary responsibilities looming but shrinking revenues, has probably, according to Rhys Edwards, encouraged the cut.

He maintains his 2017 forecast of $61 dollars a barrel due to the OPEC action which would be expected to raise prices even higher, being offset by increased production in Kashagan.

“So how does this affect our view on oil prices for 2017? It definitely shifts the risks to the upside, after news from Libya, Nigeria, and Kashagan (see The oil supply wave... Or not) tilted them to the downside two weeks ago. However, after adjusting for higher Kashagan crude production and somewhat lower OPEC output, we leave our forward oil balances roughly unchanged. Therefore, we retain our $61/bbl Brent crude oil price forecast for next year,” says Rhys Edwards.

Another factor reacting against further price gains is increased shale oil productions ever since crude rose above $40 and $50 dollars a barrel.

It is at these levels that the production of shale becomes affordable again and more shale producers have come back online, increasing production.

Although this has not managed to offset increased demand and falling stockpiles in the states, it may well do now prices are probably set to rise after the OPEC freeze.

Edwards goes on to say:

“What is not to like about the OPEC cut?

“Well, flow rates in the Permian basin have kept on improving in recent months too, meaning that US shale players keep learning how to do more with less.

“Worryingly for the cartel, production in the West Texas region has already started to increase sequentially.

“Stated differently, OPEC has declared a truce on oil prices. But relentless improvements in shale technology will keep Saudis awake at night wondering if they have made the right choice."