Adam Czyzewski

No one expected last Wednesday’s announcement by the OPEC cartel that it had struck a deal to reduce crude output by almost one million barrels a day. The news immediately triggered a 6% surge in oil prices. So what lies ahead? How does this decision affect our expectations outlined in the 2015 Integrated Report?

At the OPEC meeting held in Algiers on September 28th, oil ministers announced that at the next OPEC meeting to be held in November in Vienna they would return to supply management. The goal is to bolster crude prices by reducing output to a range between 32.5m bpd to 33m bpd, down from the current rate of 33.2m bpd. Output quotas for each member country are yet to be agreed. It is going to be a hard job since defining specific production limits for each country has always been a source of dispute and there is no reason to think that this time things will be different. This is why analysts view the Algiers agreement with wariness, as reflected by such comments as ‘meaningless agreement’ or ‘deal to make a deal’.

If in November OPEC manages to set the quotas, it will be the first output cut agreed in eight years since the agreement made in Algeria at the end of 2008, when the cartel decided to reduce production by 4.2m bpd. That deal fell apart in summer 2011, when Saudi Arabia wanted to raise the limit to satisfy growing demand. Oil ministers from OPEC countries agreed to a higher output limit at the end of 2011, but were unable to strike a deal on quotas. In consequence, OPEC countries started to produce as much as they wanted or as much as they could place on the market, which readily consumed all production without any visible effect on oil price. Everything changed in the middle of 2014, when the market was hit by oversupply.

When describing the adjustment process aimed at absorbing the oversupply, we mentioned two important factors that will emerge (i.e. drive up oil prices) when the oil market regains balance. The first one was the growing reduction of OPEC spare capacity (of which the lion’s share is held by Saudi Arabia) caused by the change of production strategy from price defence to market share growth. It has already shrunk below 2m bpd, from 3m bpd in 2014. Before the oil price slump in 2014, a buffer in excess of 3.5m bpd was considered safe. The other factor stemmed from the first one. We said that we cannot discount the possibility that when the market absorbs the surplus supply and the price of oil begins to grow, OPEC countries will revert to the short-term price management strategy, since managing prices over a longer term will no longer be effective due to production in the US being adjusted to price levels.

Now the oil market is in balance and OPEC’s decision to revert to the short-term price management strategy is already factored into our adjustment scenario. Interestingly, in the case of the largest two producers, the fierce regional rivals Saudi Arabia and Iran, the current situation is conducive to an agreement between them. The Saudis are facing a seasonal output reduction following the summer peak, when domestic energy demand increases. In 2015, monthly oil production in Saudi Arabia reached the record high of 10.6m bpd in June to fall to 10.1m bpd in December. This means that the agreement to limit total output by around one million barrels per day will only have a moderate effect on the country’s export volumes. Iran, on the other hand, is pumping oil close to maximum capacity (approximately 3.9m bpd) and will not be able to achieve any material production increase without capital expenditure. Libya and Nigeria are a source of significant uncertainty within OPEC as these countries can rebuild their output relatively quickly, and so is Venezuela, where continued output reduction would be conducive to an agreement at the upcoming OPEC meeting in Vienna.

In the meantime, the markets will be watching the situation and assessing the probability of production cuts, but with higher oil prices compared with a situation if the news from Algiers were different. Extraordinary OPEC meetings that did not end conclusively resulted in oil price declines.

What next? The prospect of production cut and higher oil prices will drive up output in the United States. This will not happen overnight: at least six months will pass before we see any new oil produced. Once it is placed on the market, the price increase will be curbed. Russia’s and Kazakhstan’s response to the deal is yet to come. The numerous uncertainties, however, remain without effect on our scenario, which envisages an oil price growth in the long term and strong short-term volatility.


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