Oil Prices To Surge As OPEC Extends The Output Cuts To End Of 2018

by Trefis Team
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As anticipated by the market, the Organization of Petroleum Exporting Countries (OPEC), along with its Non-OPEC allies including Russia, Kazakhstan, Oman, and Bahrain, announced the extension of production cuts of 1.8 million barrels of oil per day (bpd) until the end of 2018. This extension is, however, subject to a clause by Russia to reassess the terms of the deal during the OPEC’s next meeting in June 2018 based on the recovery in oil prices. While this serves as great news for the commodity markets that have been in a slump since 2014, crude oil prices did not witness a sharp rise since the announcement of the extension last week. This could be largely because the market had already anticipated the move and factored in its impact on oil prices over the past few months.

Implications Of The Extension

The OPEC’s meeting last week marked the first anniversary of the announcement of the “Declaration of Cooperation” among the OPEC and Non-OPEC members aimed at bringing stability to the oil markets. The extension of the production cuts until the end of next year implies that the OPEC members are satisfied with the rebound in oil prices so far, and are willing to restrict their production in return for higher prices to bring down their fiscal deficits. It also means that Saudi Arabia, the strongest and most dominant member of the OPEC, has managed to set aside its regional tension with Iran and continued to exempt its rival OPEC nation from the production cuts for the remaining term of the agreement.

On the contrary, smaller OPEC members, such as Nigeria and Libya, that were earlier excluded from the output moderation, have now been made party to the deal. While these two countries do not have specific output quotas, they would be expected to keep their production numbers within their highest levels attained in 2017. This would allow these countries to maintain their output levels, while not jeopardizing the OPEC’s efforts to rebalance the oil markets.

Besides this, receiving supply cooperation from Non-OPEC members, particularly Russia, is a big achievement for the oil cartel. This is because continued supply cuts could increase the risk of shrinking the market share of these Non-OPEC countries in the global markets, given the rising oil supply from the US shale producers. Nonetheless, Russia has safeguarded its interests by inserting a clause in the current extension to review the terms of its participation in the deal in June 2018. That is to say, in case the production cuts result in a speedy recovery in oil prices, the country may choose to drop out of the deal midway. However, if the US shale output continues to mitigate the impact of the OPEC’s deal, the country may continue to be part of the deal to support the rebound in oil prices.


The US Shale Boom : Potential Threat To The Deal

Since the announcement of OPEC supply cuts in November 2016, the US oil inventories have dropped by roughly 5% to 1,925 million barrels, in line with the OPEC’s expectations to bring down the global oil stockpile. However, the US output has been grown by almost 10% during the same period, offsetting the impact of the cartel’s deal. Even though several factors, such as lack of cash flows to fund the capital investment program and the growing natural gas glut, are restricting US oil and gas producers from drilling their shale plays in full swing at the moment, the jump in oil prices backed by the extension of OPEC’s output could provide an incentive to these producers to maximize their output. This is because higher oil prices are expected to strengthen the cash flows of these producers, providing them the flexibility to invest more capital to expand their output. Further, they will have excess funds to invest in newer and advanced technologies that will bring down their break-even price further and enable them to generate higher returns. Thus, the OPEC’s efforts to stabilize oil prices could be threatened by the expansion of output by the US shale producers.

That said, the OPEC as well as Non-OPEC members believe that they have factored in the impact of the surge in US shale output as a result of these output cuts. The cartel expects the oil markets to rebalance themselves by the second half of 2018, taking the oil prices to the $60-$65 per barrel range over the next few months, ceteris paribus. However, we believe the US output and rig count will continue to play a crucial role in the success of these production cuts.

Above, we present our forecast of Brent crude oil prices over the next 4-5 years. Please note that this forecast incorporates the impact of a gradual rise in the US shale production, along with the OPEC production cuts. You can create your own scenarios for oil prices using our interactive platform.

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