ETF Securities Research Blog

The mirage of deep oil production cuts

OPEC led the market to expect non-OPEC countries will cut production by 600,000 barrels per day. This weekend a group of non-OPEC countries decided to cut by 558,000 barrels per day. The market rallied. Go figure!

We believe that market optimism about the OPEC/non-OPEC deal is excessively high. We acknowledge that OPEC has brokered a landmark deal and the cartel has clearly departed from the prior two-year strategy of ‘market share at all costs’. However, what non-OPEC have signed up for falls short of what OPEC promised. That adds to the sleight of hand around OPEC’s “1.2 million barrel per day cut”. When factoring in the exempt countries and higher-than-actual production reference figures, OPEC is only likely to cut 0.7 mb/d from October levels. As highlighted in today’s International Energy Agency monthly report, OPEC was pumping out 34.2 mb/d in November, a record high and more than 1.4 mb/d higher than a year ago. OPEC’s monthly report out tomorrow is likely to confirm that members were producing at a break-neck pace ahead of the agreement.

We also believe that the incentive to cheat on the deal is always present. This is not new: game theorists have written volumes on the “prisoner’s dilemma” in cartel behaviour. The fact that many of the participants in the deal are not even part of the cartel compounds the problem.

While Brent oil is currently trading around US$56/bbl – slightly above the upper end of our range (US55/bbl) – we believe that there will be a pullback as the details of the deal are absorbed by the market. Market disappointment over compliance on the deal will not be the only trigger for price declines. At current prices, we expect US tight oil supply to accelerate, which will limit further price increases. Last week, rig counts in the US increased by 21, the highest weekly increase since April 2014, highlighting the pace at which the nimble US market is responding to oil prices above US50/bbl. We expect the supply response from the US to continue.

 

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