Oil & OPEC: Failed strategy or adapting to new market conditions?

If it ratifies the Algiers agreement at its November meeting, OPEC will have to cut its output by some 800,000 barrels per day starting in December. This would keep the cartel’s production one million barrels a day (MMbbl/d) above its 2015 average, but below the current demand growth rate (1.4 MMbbl/d).

What is behind this decision? What are the factors at play? OPEC can apply one of two pricing strategies: accommodating or squeezing.

The former consists in maximising profits by adapting to demand and setting high prices. And high prices will also allow high-cost producers to be profitable, and therefore supply more. Squeezing
means increasing output, which pushes the market price down towards the extraction cost of the least efficient producers, which consequently get ‘squeezed’ out of the market.

This last strategy is the one OPEC opted for in 2014, and the choice was subsequently shown to pay off, by the slowdown in output of unconventional oil (so-called ‘tight oil’) in the US and of oil sands in Canada.

To date, US tight oil production stands at about 4 MMbbl/d, having previously exceeded 4.5 MMbbl/d. According to the AIE’s and the IEA’s forecasts, US oil production is likely to have dropped by some 800,000 barrels per day in 2016.

Ongoing global glut

OPEC’s output cut could change the market’s fundamentals if it succeeds in reducing the excess supply, which would require, on the one hand, a stabilisation or freeze on the cartel’s production –
while allowing certain members to raise their output – and on the other hand sending out a strong signal to non-OPEC producers to discourage them from adding to the supply.

The latest data from the AIE shows that global demand is at 96.0 MMbbl/d and global production at 96.9 MMbbl/d, of which 40.4 comes from OPEC (including 7 million barrels of liquid natural gas).

There is therefore an average oversupply of about 900,000 barrels a day, not including the commercial crude oil inventories.

So if OPEC manages to cut back its production and stabilise it around 33 MMbbl/d, the market would at last be free of oversupply and have a chance to absorb the surplus. However, this scenario relies on several prerequisites: stable non-OPEC production, steady global demand, and discipline within OPEC.

Erasmo Rodriguez is Energy and Utilities Equity Analyst at Union Bancaire Privée (UBP) Geneva

ABOUT THE AUTHOR
Alicia Villegas
Alicia Villegas speaks Spanish and Italian and is Iberia Correspondent for InvestmentEurope. She was shortlisted for the Rising Star Award at the British Media Awards 2017 and Writer of the Year at the PPA Independent Publisher Awards 2016. Previously, she worked for almost three years at the seafood business website Undercurrent News as a market reporter. In Spain, she also worked for more than five years for several media outlets.

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