OPEC has thrown what it hopes to be the knockout punch that brings markets into balance and cuts down inventories. Oil fell 5% in the week prior to the meeting and then rallied at a total of over 15% on the day itself and the 24 hours that followed as markets bet on OPEC's potential success. So far, so good from their perspective, but we think that the true impact on oil supply will be less than markets are currently pricing.
We believe that production cuts are likely to be around 0.7 million barrels a day (mbd) from January through to the May OPEC meeting, once we allow for a range of mitigating factors.
So how did we reach our current estimates?
It makes sense for producers to avoid excess supply, because oil demand changes very little with price. So for example, a 1% cut in production can lead to a temporary price rise that’s 10% or more.
Prior to the recent OPEC announcement the outlook was bleak for suppliers, with Russia, Saudi Arabia, Iran and Iraq all competing to grow market share and so they put the oil price under sustained pressure. Given fiscal constraints it makes sense for all of them to target less supply and improve their fiscal positions.
OPEC estimates its production in October about 0.5mbd higher than the US Energy Information Agency (EIA). The EIA is heavily used by oil market analysts and its numbers suggest 0.9mbd of cuts rather than 1.4mbd OPEC outline.
We think that given the moral hazard for OPEC in calculating its own supply numbers, as every country wants to maximise its official OPEC share, then the US data is more reliable.
The next problem is that it’s not in any individual producer’s interests to cut their own supply. Ideally they want to bluff their partners, so partners cut, while continuing to pump at full speed themselves.
OPEC addressed this with a detailed table of cuts and a monitoring team from three smaller producers (Kuwait, Algeria and Venezuela) plus two non OPEC members. This increases the likelihood that both OPEC comply and non-OPEC members like Russia and Oman also get involved.
Historically, it’s estimated OPEC have complied with about 60% of announced cuts, so it makes sense to use that as a base rate, implying c.0.6mbd of cuts, rather than the 0.9mbd on the EIA basis. The current steps to build credibility suggest higher-than-expected compliance, so we assume a 70% rate of compliance.
The EIA projections also show OPEC production as being about 0.2mbd lower for Jan-April than in October anyway, even before the cuts. So given the cuts have been expressed as a target of 32.5mbd that suggests 0.2mbd less true cuts from what the market potentially already expected.
We also struggle to see non-OPEC cuts achieving the targeted 0.585mbd, particularly as Russia’s baseline was to raise production, but we’d think 0.2mbd is more realistic. It's worth noting Russia had a higher-than-expected October production number as their baseline for cuts too. Some countries involved, such as Mexico, were expected to experience some decline in production anyway, so their cuts aren't really anything new.
While 0.7 mbd in production cuts is still significant, it's not going to overwhelm other factors, like Chinese demand.
It's worth noting that we've only focused on the supply side and there are a number of questions which need answering to come to a firm conclusion on what this means for oil prices. Questions such as:
- The market already expects some OPEC and non-OPEC cheating, but how much?
- Will the speed of US shale oil response be faster or slower than the market expects?
- How does the outlook for supply sit in the context of the outlook for global oil demand and the debate around storage?
Nonetheless, with a broadly consensus view on most of these issues, but a more constructive view on supply volumes, we are inclined to be somewhat sceptical of today's higher oil prices and see the risks to the downside.