Why oil pro­duc­tion cuts won’t work

Financial Mirror (Cyprus) - - FRONT PAGE - By Tom Hol­land

In Jan­uary 1991, in a last-ditch ef­fort to avoid all-out war, United Na­tions Sec­re­tary Gen­eral Javier Perez de Cuel­lar flew to Bagh­dad in an at­tempt to per­suade Sad­dam Hus­sein to with­draw his forces from Kuwait.

On his re­turn to Paris, the sec­re­tary gen­eral spoke to the press in an ad­dress that was car­ried live on tele­vi­sion. Nowhere was the broad­cast watched more keenly than on the floor of the In­ter­na­tional Pe­tro­leum Ex­change in Lon­don. How­ever, no one heard more than the diplo­mat’s first word: “Un­for­tu­nately...”. The rest of his state­ment was lost in the roar from the trad­ing pits as the price of crude oil fu­tures in­stantly gapped higher, surg­ing to 20% above the pre­vi­ous day’s close. The run-up proved tran­si­tory, how­ever. By the end of that week, the price of crude had fallen back be­low $20/b, much where it had been the pre­vi­ous sum­mer be­fore the Iraqi in­va­sion of Kuwait.

At the time, deriva­tives were a new and poorly un­der­stood phe­nom­e­non as far as reg­u­la­tors, aca­demics and many in­vestors were con­cerned, with ob­servers strug­gling to make sense of their im­pact on the un­der­ly­ing “cash” mar­kets. The be­hav­iour of the crude oil price in 1990-1991 taught an im­por­tant les­son: the ex­is­tence of deriva­tives mar­kets did not af­fect the di­rec­tion of un­der­ly­ing price moves. Deriva­tives might af­fect the ex­tent of price swings, po­ten­tially adding to short term volatil­ity, but they also al­lowed mar­kets to ad­just much more quickly than they oth­er­wise would. That much was clear from the first Gulf war, when oil prices fell back to their pre-in­va­sion level be­fore the shoot­ing even started in earnest, an ad­just­ment that was in marked con­trast to oil’s move­ments at the time of the Ira­nian rev­o­lu­tion—be­fore the wide­spread adop­tion of oil fu­tures—when prices re­mained el­e­vated for years.

It is a les­son that still holds to­day. Even if OPEC oil min­is­ters do man­age to agree an out­put cut in Vi­enna this week — and that’s a mighty big “if” — the re­sult­ing gain in the oil price will prove short-lived. As a car­tel, OPEC is too frac­tured and too small rel­a­tive to the over­all mar­ket suc­cess­fully to sup­port prices much above cur­rent levels on an on­go­ing ba­sis. As a re­sult, any post-meet­ing run-up in prices will sim­ply pro­vide a sell­ing op­por­tu­nity in the fu­tures mar­ket.

At first glance, cur­rent sup­ply and de­mand num­bers sug­gest the pro­posed pro­duc­tion cut of up to 1.3mn bar­rels per day could in­deed push prices higher over the medium term. Ac­cord­ing to the In­ter­na­tional En­ergy Agency, global crude pro­duc­tion was run­ning at 97.8mn bpd last month, ahead of de­mand at 97.1mn bpd. As a re­sult, it ap­pears a mod­est OPEC pro­duc­tion cut would be enough to elim­i­nate the present crude over-sup­ply.

But OPEC is not the force in the oil mar­ket that it once was. To­day the car­tel’s mem­bers ac­count for only around a third of global pro­duc­tion, and even with the ad­di­tion of Rus­sia, their com­bined out­put is less than half the world’s to­tal. Th­ese days the mar­ginal pro­duc­ers are no longer OPEC mem­bers, but US shale com­pa­nies. And omi­nously for OPEC, well­head break-even rates in the US shale oil patch have fallen some -20% over the last year as the in­dus­try has ra­tio­nal­ized to be­tween $30-40/b. Fac­tor in fi­nanc­ing and other costs, and that makes drilling at­trac­tive for many of the sur­viv­ing pro­duc­ers at cur­rent prices of around $47/b for WTI. As a re­sult, the US rig count has risen steeply over the last six months, and US pro­duc­tion is up by some 260,000 bpd from its sum­mer low. Should prices rise much from here into the $50-60/b range then open­ing capped wells and drilling new ones will be­come eco­nomic for many more pro­duc­ers, im­pos­ing a mid-term cap on prices some­where in the vicin­ity of $55/b.

OPEC’s mem­bers know

this, of course, and ap­pre­ci­ate that if they do im­ple­ment sig­nif­i­cant pro­duc­tion cuts, they will not push up prices on a sus­tain­able ba­sis, just lose mar­ket share. As a re­sult, although OPEC may an­nounce a deal at its meet­ing to­mor­row, in­di­vid­ual car­tel mem­bers have a pow­er­ful in­cen­tive to re­nege on their com­mit­ment fol­low­ing the an­nounce­ment in an at­tempt to de­fend their mar­ket share and hence their rev­enue.

More­over, knowl­edge of this dy­namic means pro­duc­ers both within and out­side OPEC have a com­pelling in­cen­tive to seize on any posta­gree­ment run-up in the oil price as an op­por­tu­nity to go short in the fu­tures mar­ket in or­der to lock in prices above US$50/bbl. As a re­sult, although the post-an­nounce­ment spike in prices may not be as vi­o­lent as that in Jan­uary 1991, it is likely to prove equally short-lived.

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