Why oil production cuts won’t work
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.