OPEC’s production cuts are greatly overrated

Between the recent agreement by OPEC to cut oil production by 1.16 million barrels per day (bpd) and the unprecedented agreement by a group of non-OPEC countries to cut an additional 560,000 barrels per day, the world oil market could soon face a contraction in oil production on the order of 1.72 million barrels per day.

Such a cut could cause oil prices to skyrocket—at least that’s what some prognosticate. I hold a contrarian view. In fact, I contend that oil prices will most likely continue to average between $50 and $60 per barrel.

To understand my sentiment requires fresh perspective on not only supply and demand, but on the cuts themselves. How likely is it that the cuts will in fact amount to the agreed upon terms?

Moreover, we need to recognize that the cuts will be benchmarked against October production levels, and that there was a surge in OPEC production over the months leading to the historic agreement. Consequently, the cuts aren’t nearly as drastic as they may seem.

First, the fundamentals

The fundamentals of supply and demand are inexorable. In a world in which futures traders set the price of oil, temporary sentiment can push prices above or below the market equilibrium. But eventually the lights are turned on, and the market is left bare, and traders see who they’ve been rooming with.

Before jumping into the fundamentals, we need to recognize that the current market is out of balance. According to OPEC’s analysis, world oil production outstripped world consumption by an average of 1.1 million barrels per day through the first three quarters of 2016. This oversupply has pushed prices down to levels that reflect the marginal oil producer who today is drilling in one of the domestic shale plays.

Because the market is oversupplied, the volume of oil in storage has been increasing at a rapid clip, and a significant portion of this volume has been flowing into China’s strategic petroleum reserves (SPR). This is important because these volumes may not reflect what we may call “real demand,” that is demand that is associated with harnessing the potential energy that makes crude oil so valuable.

It has been estimated that China’s stockpiles have been growing at a rate between 350,000 and 400,000 barrels per day—or between one and two tanker deliveries per week. While it’s not possible to know if this will continue in 2017, it’s very possible that the rate of growth is sensitive to price. If it’s price sensitive, rising price will quickly eat into “demand.”

In looking at world oil demand, we see estimates that world oil consumption is forecasted to increase from somewhere between 1.1 million and 1.3 million barrels per day over the course of the year. This should put China’s SPR purchases in context. When considering oil demand, it’s important to understand that the rate of growth in demand depends greatly on which group of countries is driving economic expansion. The incremental oil demand associated with a unit of real GDP growth in advanced economies is much smaller than the incremental oil demand associated with a unit of real GDP growth in a developing country.

Global economic growth over the coming year is going to be less driven by China and the developing world economies than has been the case over the last decade. Moreover, interest rates are most likely going to continue to rise over the coming quarters, and as a result, the value of the dollar should increase. And as it does so, developing countries will see more of their export earnings going to debt servicing, leaving less for other activities that generate oil demand.

In addition to suppressing oil prices in the United States (where incomes are earned in dollars), developing countries will find oil and all other imports becoming increasingly expensive. This will have the effect of further suppressing oil consumption.

For the reasons above, it’s reasonable to assume that oil demand could fall short of most expectations.

Supply in consideration

Turning to supply, we need to look closely at precisely where the OPEC cuts are expected to come from. Saudi Arabia is to cut 486,000 barrels per day (kbd), or 42% of the total OPEC cut.

But here’s the rub: The Kingdom’s domestic oil consumption is highly seasonal, with demand skyrocketing during the summer months when oil is burned to generate electricity used for air conditioning. In the summer of 2013, demand increased by approximately 450 kbd between January and June. In 2014 and 2015 the direct burn increased by 550 kbd and 620 kbd, respectively.

Of course, the demand fell again over the second half of the year in each case. Looking at monthly production data, we see a similar expansion and contraction in the Kingdom’s volume of oil production. In both 2014 and 2015, Saudi production contracted by around 300 kbd between the July production peak and October. This year, production peaked in August, and only declined by around 50 kbd by October. Consequently, we can deduce that most—say 250 kbd—of the agreed to cut will be a normal part of the annual production cycle.

In truth, the agreed to cut, if followed exactly, will bring production down from 10.54 million barrels per day to 10.06 million barrels per day, which is only 70 kbd fewer than was produced in January 2016. To put this in perspective, ExxonMobil’s Baytown refinery could process 70,000 barrels in 3 hours. Given that the world was oversupplied by more than a million barrels per day in January 2016, it can hardly be expected that a reduction of 70 kbd will have much of an impact.

The second biggest contributor to OPEC’s production cut agreement is Iraq, who is on the line to cut production from 4.56 million bpd to 4.35 million bpd—a reduction of 210 kbd, or 18% of the total. Never mind that Iraqi production increased by about 250 kbd between June and October, and that the agreed to post-cut production level is basically what the country averaged over the first half of 2015. Never mind the fact that the cut will leave Iraq producing approximately the same volume in January 2017 as the country produced in January 2016.

What we really need to consider is that the Wall Street Journal got their eyes on the official delivery schedule of the Iraq’s state oil company, and that they saw and reported that planned deliveries are guaranteed to go up by 230 kbd in the early months of the new year.

As the Wall Street Journal points out, domestic consumption amounts to only 15% of production, and there’s not enough storage infrastructure to support a rise in exports and a decline in production. Thus, it seems pretty unlikely that Iraq is going to follow the dictates of the agreement. To put it bluntly, they need the oil income to fund their war against ISIS insurgents.

When we look at Kuwait, the UAE, Algeria, Angola, Qatar and Ecuador as a group, we see that the cuts will simply return production to the levels experienced at the same time last year. In fact, the only country of note on the list of countries that have agreed to cuts that will in fact see a real decline is Venezuela.

But in this regard, a lack of investment has led to a situation in which oil production has been declining at a more or less steady rate since 2003. Over this period, the country has seen production decline from 3.3 to 2.3 million barrels per day. So, a cut isn’t really a cut in this regard.

Who did not agree to reduce?

Now, let’s take a look at the OPEC members who have not agreed to reduce production. While Iran is technically a signee, they have in reality agreed to not increase oil production by more than 90 kbd, which will return the country to the level that was last seen before the oil sanctions were imposed. This is an interesting take on the concept of a “production cut.”

This leaves Nigeria and Libya. In both countries, production today is a fraction of what it has been and could be because of militant activity. Libya was just in the news because they are now reopening a field that was shut in during the war. This should lift the country’s output and exports by 450 kbd, and bring the oil production back above 1.0 million barrels per day. And even then, there is room for continued improvement, as the country averaged 1.4 million barrels per day of oil production over the period of 2012 to 2013.

Nigeria has recently been in the news as well, with the President announcing the government’s intentions to better defend oil infrastructure in the Niger Delta, thereby allowing lost production to be regained. If effective, Nigerian oil production could increase by between 200 kbd and 500 kbd, though I would bet that the former is more likely.

So, when we look at the total, we see that OPEC will most likely be producing more oil in the early part of 2017 than was produced over the same period in 2016.

Turning to the non-OPEC countries that agreed to cuts, we see Russia rise to the top of the list. Call me a cynic, but I don’t have much faith that Russia will indeed cut production—and they were on the hook for around 300 kbd of the total. Mexico and Azerbaijan are also on the list, but the cuts that they have agreed to are simply in line with their long-term oil production decline rates.

What’s the story?

When we take a closer look at the numbers we see a different and much less alarming story than many in the media are selling. It seems likely that oil production from Iraq, Libya, Iran and Nigeria will increase by nearly 1 million bpd. And when we look at the rest of OPEC, we see that production levels might be down by 100 kbd to 200 kbd over Q1 2016 production levels.

If that wasn’t enough to convince you that the OPEC cuts are not likely to strongly affect prices, consider that production in United States shale plays has just begun to see a recovery. The number of active drilling rigs has been climbing slowly but steadily since June, and October production was up in the Bakken and the Permian—the two most prolific shale plays. And the reason why is that the cost of production has plummeted while well productivity has skyrocketed. Indeed, there’s money to be made even at $50 per barrel.