OPEC has agreed to reduce current production levels in the first such move since the 2008 global financial crisis. The deal marks a major reversal of the “free-for-all” market-share strategy that Saudi Arabia and other Gulf Arab states have adopted in recent years as they sought to drive down prices and undermine US shale producers. However, there are reasons to doubt that the agreement will hold, not least because of weak enforcement mechanisms and the prospect of rising US shale production should prices rise significantly. Consequently, The Economist Intelligence Unit will not make substantial changes to its oil price forecast, which currently stands at an average of US$45/barrel in 2016, rising to US$57/b in 2017 and US$61/b in 2018.
The response to the deal from the markets has been vigorous, although it was largely psychological, driven by speculative activity and paper—rather than physical—trading. The price for Brent crude futures—the international benchmark for oil prices—soared by nearly 9% to over US$50/barrel. Other major producers outside of the cartel, including Russia, have also agreed to trim their output by 600,000 barrels/day (b/d). The details of how the latter will be achieved are scant, but a meeting with non-OPEC producers is scheduled to take place on December 9th in Doha. In any case, effective January 2017, the oil cartel, which pumps one‑third of global oil output, will trim its current output level by 1.2m b/d to 32.5m b/d for six months (January-June). Whether the accord will be rolled over for another six months largely depends on whether the agreement translates into (sustained) higher prices.
Although OPEC’s ability to set prices has weakened considerably with the rise of US shale, the deal demonstrates that the cartel can still exert some market influence. This was not easy to achieve, given divergent views within the organisation over who should bear the brunt of any cuts. In particular, Saudi Arabia, Iran and Iraq have been at loggerheads for a long time over how the cuts should be apportioned. Iran claims the right to return to levels prior to stringent international sanctions introduced in 2012, and Iraq maintains that it needs to finance a costly war against the jihadi Islamic State group.
With this in mind, Saudi Arabia has agreed to shoulder much of the burden and to reduce its output by 486,000 b/d to 10m b/d. (However, the rate of reduction, at 4.6%, is almost identical to the rate applied to most other OPEC members.) This was largely expected, as Saudi Arabia was the main beneficiary from the imposition of international sanctions on Iran, which enabled the kingdom to boost its output by 2m b/d since 2011. Following Saudi Arabia’s lead, other Gulf Arab states—namely Kuwait, Qatar and the UAE—have also said that they will scale back production by 300,000 b/d, with the remaining cuts to be distributed among the other members of the cartel. Oman, the largest non-OPEC producer in the Middle East, has been critical of OPEC’s previous push for market share and would be likely to approve the suggested cuts, given its external and fiscal dependence on oil revenue. Meanwhile, Iran has agreed to freeze its output at 3.8m b/d, and Iraq has accepted a cut of 210,000 b/d to 4.35m b/d. Exemptions have been made for war-torn Libya and Nigeria, whose economies have suffered the most as a result of armed conflict.
Committed to cut?
A breakdown of the new OPEC quota shows that a cut of around 4.5% will be applied across all of OPEC’s members—with the notable exceptions of Libya and Nigeria—effective January. However, the baseline figures on which the cuts will be applied perhaps overstate current production. One striking example is Iran, whose average production in October—based on secondary sources in the OPEC Monthly Oil Market Report—stood at 3.69m b/d. However, the baseline figure used by OPEC to calculate the country’s new quota is 3.98m b/d, which is Iran’s 2005 peak output level before it came under sanctions. The inflated baseline means that Iran’s quota in January will be 3.8m b/d, which will allow the country to raise its production on the current level (rather than freeze it) by about 107,000 b/d. Similarly, Angola produced 1.59m b/d in October but the baseline on which a 4.5% cut was applied was 1.75m b/d, the country’s average production outturn in September. On top of this, there is room for significant expansion in Libyan and Nigerian output, a scenario that could make the reduced OPEC quota impossible to honour.
|The new individual country quotas|
|(‘000 b/d, unless otherwise stated)|
|Member country||Reference production level||Adjustment||Production level effective January|
|Indonesia has suspended its membership; Libya and Nigeria will be exempted from production cuts.|
|Sources: OPEC; The Economist Intelligence Unit; secondary sources.|
There is no guarantee that the deal will last either. Saudi Arabia has made its participation in the accord conditional on co-operation from outside the cartel. The Russian energy minister, Aleksandr Novak, has already made it clear that cuts to Russian output will be “gradual” and conditional on “the maximum participation of non-OPEC countries”. It is likely that Russia’s stated commitment to curb its production will not be enforced in practice, not least because of the expected arrival of a number of new oilfields in 2017, which will push up the country’s production above the current post-Soviet high of 11.2m b/d in October. In the same vein, OPEC members have poor records when it comes to compliance with such deals.
Good news for shale
Perhaps more crucial, the response from US shale producers will determine the longevity of the OPEC agreement. After surging from around 7m b/d in 2008 to a peak of 13m b/d in April 2015, on the back of a boom in shale output, US oil production fell to 12.1m b/d in August 2016 as persistently low prices prevented cash-strapped and indebted shale producers from making the necessary investments to sustain output. However, OPEC members will be aware that even a small recovery in prices will incentivise the US oil industry, which has shown some resilience over the past two years. Shale producers have adapted their technologies to reduce production costs. A risk of surrendering market share to shale producers could therefore materialise in the event that OPEC members respect their quotas.
The success of the OPEC deal also depends on demand-side developments. Once again, there are a number of downside risks, notably the possibility of Chinese growth slowing by more than we expect, as well as further crises in the euro zone. Nonetheless, after two years of contraction, we expect the economies of Brazil and Russia to return to expansion in 2017, providing support for oil demand. There will also be a modest strengthening of Middle Eastern economies, led by Iran. Buoyant economic growth and investment, as well as booming vehicle sales (especially of motorbikes), will continue to drive growth in India’s oil consumption in 2017‑18.
Arguably, the fiscal pain felt in many of the oil-producing countries since 2014 was the unifying factor behind OPEC’s decision to return to collective action. However, we do not expect the deal to have the significant—let alone lasting—impact on oil prices that the cartel is hoping for. Given the temptation to break the new quotas and the ability of non-OPEC producers to increase their output, a sustained increase in oil prices for a prolonged period of time appears unlikely.