OPEC cuts to tighten market further

OPEC+ agreed to cut production by 2m b/d from its August baseline levels after meeting in-person for the first time since the pandemic began in 2020. The exporters’ alliance noted the “uncertainty” around the outlook for oil makers and also sought? to provide “long-term guidance” as justification for the output cuts. OPEC+ also extended its declaration of cooperation, the agreement to coordinate production policy, until the end of 2023 and will move to ministerial meetings being held every six months, rather than every month at the moment.

OPEC+ does have some merit in trying to anticipate a period of slower growth in oil demand. Risks to oil demand growth are skewed to the negative as economies respond to substantially tighter monetary policy, high inflation, and slower economic activity. While a total collapse like the market endured in 2020 is highly unlikely, a considerable slowdown in the pace of demand growth looks set for next year, though total demand probably won’t shrink. However, there is a risk of demand outperforming should China adjust its zero-Covid strategy and activity bounce back sharply from its current doldrums.

Cutting production also worsens an already fraught supply picture. OPEC+ has been missing targets in aggregate thanks to underperformance by several members, Russia faces a shrinking list of destinations for its exports thanks to sanctions, and investment outside of the OPEC+ grouping has been lagging, keeping production from countries like the US at an effective standstill. At the same time, global inventories have been drained as governments responded to high oil prices by releasing strategic reserves: total US crude oil inventories have plummeted as SPR stocks have been released.

US oil inventories have been drained: strategic and commercial stockpiles

Source: EIA, Emirates NBD Research

Ministers from OPEC+ nations cited the uncertainty in the current market conditions as warranting “pro-active” and “pre-emptive” moves, according to Abdulaziz bin Salman, the energy minister of Saudi Arabia. Suhail al Mazrouei, energy minister of the UAE, said the cuts were “technical” in nature and did not reflect the current geopolitical environment. Russia’s energy minister, Alexander Novak, did say that a mooted oil price cap from the G7 countries could lead to a temporary production cut as importers will find challenges in securing services to import Russian oil.

By sticking to August baseline levels, the 2m b/d targeted cuts will be watered down considerably. Of the 19 members of OPEC+ that have been participating in production targets (Mexico is included but has not participated), we estimate only seven will actually need to cut production from November onward if using August targets as their baseline. Most members of OPEC+ currently have production targets higher than their recent output so will not need to cut. All of the actual cuts will come from producers in the Middle East and Africa with Saudi Arabia, the UAE, Kuwait and Iraq required to make the largest adjustments to hit their target level. For the UAE, its allocated production cut of 160k b/d would be too small to hit its new target level given it has been ‘over-producing’ in recent months and it would in fact need to cut by closer to 380k b/d.

Who's cutting and how much

Source: IEA, OPEC, Emirates NBD Research

Market response to the cuts was relatively mild given that they had been expected and the headline cut was immediately neutralized by sticking to old baselines that don’t reflect existing oil market realities. Brent futures have bounced by about 11% since hitting a recent low of USD 84/b, pushing back up above USD 90/b, while WTI has also recovered, moving further away from the high USD 70s handle it had hit recently and closing in on USD 90/b in response to the OPEC+ decision. We had outlined previously how markets face a strained supply picture and that oil prices will likely push higher going into 2023 and are holding to that view for now.

Importing nations may choose to respond by releasing more of their strategic reserves with the US administration responding to the cuts immediately by saying they were “disappointed by the shortsighted” decision and that the president will continue to “direct SPR releases as appropriate.” However, further legislative responses—the oft threatened NOPEC bill in the US for instance—are unlikely to be effective in prompting more oil from the OPEC+ alliance. Draining inventories more may actually keep the market even more anxious and prompt an even bigger bid under near-term oil, steeping out the backwardation in markets.