Drilling for an explanation to the OPEC+ cuts

On April 2 OPEC+, a group of 23 oil-exporting countries that meets regularly to decide how much crude oil to sell globally, surprised both the financial markets and diplomatic circles by announcing a significant cut in daily oil production of more than 1.6 million barrels per day (mb/d) that will last through yearend. Senior Investment Director of Emerging Markets, John Mensack, sat down with Commodities Portfolio Manager Malcolm Melville to understand the drivers and ramifications of this action.

Malcolm, how surprising was this move by OPEC+?

Very surprising. The group reported this major change between its scheduled meetings, which is quite rare for this institution and this aberration speaks volumes. Prior to the announcement there was a sense among experts that OPEC+ was relatively satisfied with oil’s level of production and pricing because OPEC+ had recently stressed that the current framework was set to stay until the end of the year. When the announcement occurred, Brent was trading just below $80/bbl—a level seen frequently in past months, making the timing harder to understand. OPEC+ has been at pains to point out the stability in the oil market versus the coal and natural gas markets, so it is difficult to comprehend an abrupt cut.

What is the magnitude of the cut and how will it trickle down through producing countries?

OPEC+ announced voluntary cuts of 1.16mb/d by eight members but the bulk of the cuts that achieve the net reduction will come from just four key producers: Saudi Arabia (0.5mb/d), Iraq (0.21mb/d), UAE (0.14mb/d) and Kuwait (0.13mb/d). Additionally these slashes to production are in addition to the previously announced 0.5 mb/d cut by Russia, which was extended until the end of 2023, to total 1.6 mb/d.

We use the term “voluntary” to describe the cuts because they sit outside the normal OPEC+ quota framework but I think they will in fact materialize and reduce the suggested amounts from market production each day. There’s a strong solidarity within OPEC+ so there is no reason to doubt whether the cuts will be implemented.

What do you think were the motivations behind the move?

This is the key question. I can only speculate but I think there could be two principal explanations. First, it’s possible that OPEC+ is expecting a sharp global slowdown. In this scenario OPEC+ is merely getting ahead of inevitable production cuts as it did in Q4 2022. We know OPEC+ monitors oil demand closely and produces detailed economic forecasts monthly but this latest action is still exceptionally bold given that the organization forecasted healthy year-on-year demand of 2.23 mb/d in the March 2023 Monthly Oil Market Report. To justify a cut of this magnitude, from purely an economic perspective, it must expect an event on par with the Global Financial Crisis. Moreover, many arbiters, including OPEC+, are expecting a robust increase in aviation fuel demand as China reopens to most notably drive oil demand growth in 2023. Given the normalization of travel demand in many countries following Covid lockdowns, such a forecast is entirely plausible.

My second possible scenario is that this is a geopolitical statement. As you know, the US conducted a rather significant draw from its Strategic Petroleum Reserve (SPR) last year to the tune of 180 million barrels. OPEC+ did not cut its production during that six-month period in response. The US indicated it would begin to refill when crude prices fell into the price range of $68 to $72 per barrel. Crude recently achieved that price level but the US took no action to begin refilling its SPR and US Secretary of Energy Granholm said it would be difficult for the US to take advantage of low prices. It’s certainly feasible that OPEC+ views this inaction as the US reneging on a tacit promise and has decided to take matters into its own hands to support prices.

It is also becoming clearer that the influence of the US on Saudi Arabia is waning rapidly. We may be seeing the beginning of the end of the petrodollar that has been in place for more than 50 years. As Russia and China agree to settle transactions in currencies other than the US dollar, the old order, under which the US provided security and economic support in return for oil pricing in US dollars, is at risk of unraveling. OPEC+ is increasingly doing what is in the best interests of OPEC+ and in this case it may be establishing $80/bbl as a floor in the oil market to finance domestic agendas.

Is this move temporary?

Considering how out of the blue the recent announcement was, it is hard to know, but your answer hinges on what you view as the motivation behind the cut. If you believe a significant economic shock is imminent, then these cuts will likely persist as demand falls precipitously. But if you think there are other factors at play, then it is hard to see the cuts lasting the whole year because the market is likely to move into a significant deficit, driving prices materially higher and negating the need for OEPC+ to maintain the cuts—unless OPEC+ wants prices comfortably above $100/bbl, in which case the cuts are here to stay.

What does this mean for US plans to refill its SPR?

By failing to take advantage of lower prices, the Biden administration lands in a tricky political position, particularly if oil continues to recover. It will either need to spend more money to top up the reserve balance or roll the dice and wait to fill when, and if, the price gets back to the lower levels recently seen. This could hand Republicans a powerful talking point heading into next year’s election. Remember: the SPR is sitting at levels it hasn’t seen since the 1980s.

Does this leave the oil market in a surplus or a deficit?

Schroders is not forecasting a rapid economic slowdown at this stage, as the Schroders Economics Group is currently forecasting global GDP of 1.9% in 2023. With this level of global growth and OPEC+ cuts, the oil market is likely to fall into a significant deficit—greater than 1.5mb/d—in 2023.

In the past when we have seen deficits of this magnitude for two quarters or more we have witnessed a rapid rise in the price of oil, as seen in the chart (Figure 1).

Figure 1: Scenario analysis of recent OPEC+ cut versus historical market balance

Source: Schroders, OPEC data, March 2023.

What does this mean for the level of risk premium that must be priced into the oil markets going forward?

There is no debating that the price of oil should carry with it a higher risk premium on a go-forward basis given the capricious nature of this move. It’s always possible this could be a one-off move designed to make a geopolitical statement but the market can have no significant level of confidence in taking that at face value. OPEC+ has demonstrated its willingness to act decisively to the surprise of almost everyone and oil prices need a premium to reflect its increasingly unpredictable approach to oil supply management.