OPEC+ Saves the Day
On October 5, the Organization of the Petroleum Exporting Countries and Russia (OPEC+) decided to cut its output from its baseline levels by 2 million barrels per day. This decision was despite the lobbying efforts by the US that aimed to prevent the cuts which continued until the very minute of the decision. While the advertised amount of the cut is 2 million barrels since many OPEC+ member countries are failing to produce as much as their quotas allow, the effective amount is expected to be around 900 thousand-1.2 million barrels per day.
The decision’s immediate impact was an increase in the price of Brent, a primary crude oil benchmark, from 84 dollars before the whispers of an OPEC+ cut to 98 dollars. Several tailwinds support the crude oil prices at the current levels, but the headwinds will likely prove more important, and oil prices will slowly trend downwards shortly.
Market Tightness is Still Very Much There
There is no denying that there are numerous signs that global oil production is not enough to satisfy the total demand right now. The major global benchmark for crude oil future price curves, WTI and Brent, are highly backwardated, and last week’s OPEC+ decision only steepened the curves.
“Backwardation” means that the longer-term futures prices are lower than near-term prices. Hence, the current supply and demand conditions are more favorable for higher oil prices than the expected future conditions. (Roughly speaking, that is, this is due to futures prices not only reflecting expected future conditions, but also being affected by various financial and material costs and quirks). The primary reason for this is that the global (except China) crude oil inventories are now much lower than the 5-year range and are being drawn down rather than built up. For market participants, this is a crucial indicator of a tight market. The latest OPEC+ production cuts are expected to cause further inventory declines, which will support oil prices at least until the end of the year.
Higher Spare Capacity
The problem is this decision also pushed the spare capacity of the OPEC+ countries higher. Spare capacity is an important measure because it shows how much the oil production globally can be ramped up in case of any supply disruptions or disorderly price spikes that might impair the stable functioning of the oil markets and the global economy and the more OPEC+ cuts production now, the more spare capacity there is for the future. But this is, perhaps, a relatively minor factor in the grand scheme of things.
Central Banks Are Pushing Back
A much more impactful factor is the global financial cycle. Almost all of the major central banks all over the world, chief of which is the Federal Reserve (The Fed), the central bank of the US, are hiking interest rates with a speed unseen for the past two decades as a result of skyrocketing consumer and producer price inflation figures that approached two digit-levels in a significant number of developed economies. The moves by the Fed are powerful because its actions are a primary driver of the strength of the US Dollar recorded in the last two quarters, and an appreciating US Dollar significantly tightens global financial conditions. In the context of oil, a strong USD means that oil imports are getting more and more expensive for the developing world, which creates almost the entirety of the global oil demand growth. Typically, this would mean lower oil prices, but OPEC+ actions since 2020 and the US being a major producer itself now meant that this negative correlation broke down. As a result, oil and energy prices are approaching never before seen levels in the majority of the world, pushing the rest of the world central banks to hike interest rates more in order to support their weak currencies and decrease their domestic demands.
The latest OPEC+ decision will likely prompt the Fed to keep going with massive rate hikes and prevent it from cutting in 2023, as was the base case of the market before the events of the last week. This is not only because higher oil prices will impact the current inflation dynamics, but also because oil prices are the main driver of household and market inflation expectations and an important professed goal of the Fed is to prevent an un-anchoring of expectations.
The Global Economy Is Not OK
The moves by the central banks would have been tolerable if only the global economy was not headed towards a synchronized decline in production and consumption. Europe is already battling sharply decelerating economic activity, as the electricity and natural gas prices for the entire continent have shot up since the war in Ukraine. A sizable number of producers in energy-intensive industries had to shut down. A further energy shock might tip the scales towards an abrupt recession, which in turn means a decline in oil demand.
China is also amid a slowdown because of the Covid-19 related shutdowns in major cities and a near-collapse in its housing and construction industry. It is difficult to determine the path the Chinese economy will take as many speculate that the shutdowns and zero-Covid policy will cease after President Xi Jinping is selected for his third term. This assumption is built into the current prices. If this doesn’t happen, it will further dent the global demand for energy commodities.
Things Will Get Political
On top of the adverse economic environment described above, the optics of the OPEC+ decision and the possible backlash against it might also provide create unexpected setbacks for OPEC+ members. While the OPEC+ statement framed the decision as one in pursuit of balancing the market in recognition of the headwinds that global oil demand will face, President Biden might choose to fight back against the price impact of the cuts because of the US midterm elections in November, as gasoline prices and approval ratings of President Biden are highly correlated. The statement from the US on the decision to cut already portrayed it as “OPEC+ siding with Russia” and “short-sighted.” There are several options, any one of which might help push the prices downward, at least in the near term.
The first option is to allow more Strategic Petroleum Reserves (SPR) releases. The SPR releases this year were already one of the reasons why US oil prices rose less than global prices this year. Another is to remove some of the secondary sanctions on Venezuela that would allow it to ramp up its oil production, which dwindled for years due to US sanctions. The US is said to have already offered this to the Venezuelan government in return for relatively minor concessions. Perhaps one relief for OPEC+ is that the JCPOA talks that might allow Iran to increase its oil output dramatically seem to be shelved for now.
In conclusion, last week’s OPEC+ production cut seems to have saved the day by pushing the oil prices back above 90 dollars, but by doing so, they also strengthened the very headwinds that forced the prices below 90 in the first place. Unless the global recession fears turn out to be exaggerated, central bank rate hikes stop earlier than expected, and Chinese economic activity restarts, it is likely that below 90 is where prices are headed.