OPEC Appears To Be Delivering On Production Cuts, So Why Aren’t Prices Rising?

Crudefunders |

At Crudefunders, our energy economist has been analyzing the crude oil markets for years and seen all sorts of price movements, and several, quite honestly, defy logic! Trust us when we say we’ve seen it all over the years. We’ve seen prices move with the news and we have seen prices trade contrary to the news. We’ve seen prices move on the expectation of news and we’ve seen prices move, just because. Coincidentally today, the crude oil trade has been reacting in one of those contrary ways in light of OPEC’s internal agreement to cut production. So this week, we want to focus on what effect this agreement is actually having on prices. Should they go higher? We’ll see!

Financial analysts from around the world have been hyper-focused on whether OPEC would indeed cut their crude oil production as promised by 1.2 million barrels per day by the end of January and keep it there. Monday’s report from OPEC surprised everybody as it proved the naysayers wrong. The report, dated February 13, 2017, showed a remarkable adherence to their promise, as OPEC cut 890,000 barrels of production, representing 93% compliance to the 1.2 million barrel target. The bottom line here is this, they did cut production and prices have recovered back into the $50-plus range as hoped. But why are they stuck there; sometimes going up to the mid $50s then back down to the low $50s?

Even with the news of OPEC’s compliance, the trade discounted the OPEC report and shelved it as “yesterday’s news”. They completely disregarded the report, stating their belief that OPEC can’t keep the cuts in play for the needed six months, which will be required to reduce the critical oversupply of crude oil around the world. There had to be more to it than that, so we decided to investigate a little further. We went back to when the Saudi’s suggested a production cut back last August and began our research there.

Just Six Short Months Ago!

When OPEC first floated the idea of a production cut, we all were skeptical of their ability to deliver on such a bold promise. After all, it had eight years since OPEC attempted to cut production and that cut was a bust. Analysts across the globe wrote on the probability, not the possibility of a complete failure in this agreement to cut production. When the possibility of the agreement was first discussed in the press, back in August of 2016, OPEC was producing 31.5 million barrels of crude oil per day and was, in fact, increasing production. The Saudi’s even reported a record high production level of 10.7 million barrels per day in August of 2016. At that same time, the U.S. was producing 8.4 million barrels per day of West Texas Intermediate crude oil; down from our record high of 9.4 million barrels per day as reported in June of 2015. (See chart below)

You might remember, from last week’s article, we quoted Stephen Schork saying, “For every single barrel of production the U.S. took off the market beginning in late 2015, OPEC increased their production by two barrels.” We were reducing our production from the middle of 2015 to the middle of 2016 and OPEC was increasing theirs all along. So you can’t blame analysts for not trusting OPEC’s bona-fides, as this agreement appeared to be a flip-flop from their long-standing position on production.

However, when the announcement was made last August, and as the prospect of this reduction in production filtered through the market, crude oil prices began to rise on the expectation of lower OPEC production. U.S. producers decided to join most of OPEC and began to increase U.S. production as well. It’s a simple economic law, that if you raise the price of a good, to some point either at or above its break-even cost of production, production will increase. In other words, better prices brings on higher production.

Several other factors contributed to this pricing conundrum as well, with crude oil stocks at record levels in the summer of 2016 showing nearly 525 million barrels in storage. The Baker Hughes Rig Count reported crude oil land-based rigs were at just 396, down from their 2015 high of 1415 working rigs. The U.S. had successfully pulled its own production down after prices took a beating around the world and with that, the price for WTI crude oil, in August of last year, averaged right at $45 per barrel. Remarkably, that was up from the middle $20s in February of 2016.



Then on November 30, 2016 OPEC did officially agree to cut 1.2 million barrels per day out of their crude oil production and the Russians agreed to cut their production another 300,000 barrels per day as well along with a couple others. The news of OPEC, plus Russian and other production cuts, was met with skepticism. One headline in a financial publication read something like this, “OPEC Confuses Its Skeptics, With First Cut in Crude Oil Production in Over Eight Years.” Very few actually thought the agreement would happen, or for that matter, most figured compliance with the agreement would be all but impossible to attain. So the markets were being set-up to catch prices on their way back down, not up!

Here’s Where We Are!

By means of re-setting the stage, we should note that OPEC’s production rose 1.53 million barrels per day, from August 2016 to December 2016, when the OPEC production cuts were to begin. In contrast, U.S. production only rose 326,000 barrels per day during that same period. So, we have to ask ourselves, what positive impact should the OPEC production cuts actually have, anyway? Especially when production overall, went up. Now, it appears we are giving definition to the price of crude oil; up on the expectation of lower production, down on the reality that production actually went up prior to the beginning of the cuts. Now we are one month in and prices keep bouncing around in a crazy channel between $52 and $55 per barrel. We’re not sure if OPEC will keep their promise and hold their production at the 1.2-million-barrel level and, on top of that, where U.S. producers will take their production. This is why prices have been so fickle!

Today, U.S. production continues to increase and currently stands at 8.978 million barrels up 518,000 barrels from August of last year, still not as much as OPEC increased from August to December. With OPEC’s production at 32.14 million barrels at the end of January, it is still up 640,000 barrels; even with the 890,000 barrel cut! These are the numbers.

OPEC’s focus from the beginning was to stabilize their own production and force prices back to where they could begin funding their member’s treasuries. Their mission was to re-capture prices for themselves, not some benevolent mission to balance the world’s crude oil price.

Meanwhile the objective of many in the international financial world was to blame the U.S. shale producer for pushing inventories back up, while OPEC was saving the world’s crude oil price. While that seems logical, the facts are clear, all OPEC did, was to appear they were reducing production, to help rally prices. They succeeded, right up to the point when folks did the math! It’s like a store owner raising his prices 50% then offering a sale price with a 10% discount. People just don’t like to be played!

What to Expect Next!

Let’s assume the effects of OPEC’s production cuts are zero, and that’s being gracious. The only way to protect prices and counter an increase in supply is to either cut production or increase demand. Fortunately, that is exactly what we are seeing. I recently read an article that talked about how global demand for oil could outdo a 10-year trend, as the health of the world economy improves and demand for transportation fuels continues to grow. New data from OPEC on Monday suggested demand for crude oil will grow at 1.2 million barrels per day, up slightly from last year’s estimates and well above the one million barrel per day average seen in the early 2000s. While we can’t take our eyes off growing US inventories, a healthy increase in U.S. demand, as well as China and India, will gobble-up excess supply in short order.

So, as we watch prices roll around in a $3 channel, increasing demand will save the day. Just to be prudent, however, we’ll still keep an eye on U.S. crude oil inventories. Last week’s Energy Information Agency report from the Department of Energy showed one of the largest builds in crude oil inventory on record here in the U.S. This is a watch point for analysts going forward and we would suggest we all keep a watchful eye on inventories for a bit longer to see where they will go.

If you want more information on the energy markets and what is making prices move every day, go to our website www.crudefunders.com and scroll down to where it says “Subscribe”. There you will find our link to the daily commentary “Energy Wise”, a comprehensive piece that includes both fundamental and technical analysis of the day’s energy markets and provides you with the detail that you need. For more on Energy Economist Tim Snyder and his company, go to www.matadoreconomics.com .

Tim Snyder

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