Extending the Cuts?

After years of market-led oil production, OPEC and a number of non-OPEC states agreed in late 2016 to cap oil production at 1.6 billion barrels a day (b/d) in an attempt to raise prices. In May 2017, the countries agreed to extend the cap through March 2018, and there is talk now of extending the cuts through the rest of 2018. With this possibility, we should take a look at the original cuts and see how they have performed.

Why the Deal has not Raised Prices

As I have written earlier, there were three reasons to be skeptical about the effects of the agreement. So far on the first count, whether the signatories will actually stick to the deal, I’ve been wrong: the deal appears to be sticking, with the notable exception of Russia. Yet my second and third points, the American oil industry and sluggish global growth, hold. On November 20, 2016, when the deal was finalized, Brent oil was $51.58/ barrel. As of 1:15PM today (September 27, 2017) it was $57.58/barrel, according to Business Insider Commodities. Overall, these points have ensured that oil will be hard pressed to break $60/barrel, let alone the rosy predictions of $70/barrel.

In 2011 the United States became the world’s largest producer of petroleum hydrocarbons. Not only has it maintained the lead since then, it has increased it year-on-year. There are more than twice the number of oil rigs in the US in 2017 than there were in 2016. This increased production is filling the exact void that OPEC had hoped would raise prices. If OPEC does extend the cuts through all of 2018, it will actually help the revived American oil industry. Moreover, as Scott Pruitt at the EPA cuts regulations and Ryan Zinke opens up more land for drilling, US oil production will pass its current 9.5 billion b/d, to hit, as the Department of Energy predicts, 10 billion b/d.

Even as US supply increases, global demand is slowing. BP predicts that demand for oil will only increase an overage of 0.7% a year for the next two decades. It also suggests that the pattern of growing supply, slowing demand, and increased efficiency will be long-term trends, meaning OPEC is unlikely to get the relief it needs anytime soon. The entirety of that 0.7% will come from emerging economies, with China playing a big role. Yet betting on China would be risky, as it increasingly turns to renewables and natural gas to fuel its industrialization. If China is able to make renewables and natural gas a key part of its industrial strategy, we can expect other developing economics to follow suit, as the giant Chinese market further lowers the costs of such fuels. Slowing demand thus hides a double-edged sword: not only is demand for oil slowing, but it is also being replaced.

Extending the Deal

Currently, the cuts extend until March, 2018 but there are talks about extending them an additional three to six months. Such an extension would be the “worst-case scenario” for OPEC. The Iraqi Oil Minister even believes that the cuts should be increased by 1%. Yet Iraq epitomizes a key problem with OPEC: compliance. As said above, most of the deal’s signatories have held to the bargain, but this has fluctuated. While in August, non-OPEC members cut more than they were obliged to (119% compliance) that same group failed to meet their obligations in July (only 69% compliance). OPEC itself says Iraq, a member-state, is non-compliant. Enforcing compliance will become even harder as prices fail to rise and signatories see other states’ oil industries fill any gap they make.

OPEC will likely extend the cuts through 2018. The market has not adjusted the way the cartel wanted. Signatories are in a bind: they can either continue the cut, lose market share, and hope that prices will rebound or they can forgo the agreement, increase production, and see prices fall. Either way, US production and slowing global demand, forces beyond OPEC’s control, ensure that the cartel has less market power than it did just five years ago.

Yes, oil may break $60 a barrel. But remember that the original goal of the cuts was to bring the price closer to, and possibly break $70. On that front, the cuts have failed, and simply extending them is unlikely to have better results.

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