The Fuse

Despite OPEC Rhetoric, Supply Cuts Not Beneficial for Consumers

by Matt Piotrowski | December 13, 2016

It took months, but OPEC was able to put together a deal to slash output by more than one million barrels per day while also convincing a number of non-OPEC producers to chip in with their own cutbacks. The overall deal, if implemented fully, would remove some 1.8 mbd of crude oil off the global market starting at the beginning of 2017. This action is set to slim down inventories, create a supply/demand deficit, and boost prices, or at least put a floor under them. In just the past two weeks since it announced the output cut, the cartel has significantly altered market sentiment and shifted the oil market outlook for next year.

How prices act going forward is still up in the air, as OPEC and its non-OPEC counterparts have to follow through on their pledges in order to realize their goals and shale output in the U.S. is poised to rebound. Just as importantly for OPEC, it has to sell its message to a number of parties, including oil traders, independent producers, the majors, and consumer countries. The cartel has already launched a PR blitz to convince numerous audiences that its output cuts will bring stability to the market, which in turn is a net benefit to the global economy. In fact, OPEC Secretary-General Mohammad Barkindo, speaking in Washington, DC on Tuesday, stated that while the agreement is beneficial for all producers, it is also a good deal for consumers. He argued that the supply cut represents for the first time a “convergence between producers and consumers,” adding that the higher price stimulated from the cuts will boost longer-term investment and overall stability.

On the contrary, OPEC coordinating action to take supply off the market does not help consumers. Instead, it creates an atmosphere of uncertainty, increased volatility, and higher costs for transportation. Moreover, it shows that producers will take extraordinary action to collude amongst themselves to control the market.

“Any naysayers that have had doubts of OPEC’s efficacy were proven wrong with the historic decision that was made by us recently.”

“I am here to report that we are still alive and well,” Barkindo told the audience at the Center for Strategic and International Studies (CSIS), touting the unprecedented coordination involved in the latest deal. “Any naysayers that have had doubts of OPEC’s efficacy were proven wrong with the historic decision that was made by us recently.”

OPEC brings in non-OPEC players, spurs volatility

There will be 11 non-OPEC producers participating in the cut, while all OPEC countries—except for Libya and Nigeria, which both have special exemptions—have agreed to throttle back. Barkindo’s visit to the U.S. includes meetings with the International Monetary Fund and “select leading” hedge funds, along with speeches at CSIS and Columbia University’s Center on Global Energy Policy, reflecting the extent to which OPEC is trying to sell its message.

Volatility harms consumers, whether motorists or businesses, as it disrupts their ability to budget and fosters an overall uncertain economic environment.

Convincing consumers of the virtue of OPEC actions will be difficult. While U.S. producers have been given a lifeline by the recent OPEC deal, consumers have already taken a hit. For one, higher volatility is one outcome that is assured from OPEC’s actions. Volatility harms consumers, whether motorists or businesses, as it disrupts their ability to budget and fosters an overall uncertain economic environment. International Energy Agency (IEA) Director Fatih Birol said last week, “This volatility may be with us for some time. We are entering a period of greater oil price volatility.” The Energy Information Administration (EIA) wrote last week: “Implied volatility increased in the weeks prior to the OPEC meeting, suggesting significant uncertainty regarding both the prospects for the recent agreement and its potential implications for global oil balances.” To be sure, price fluctuations have been commonplace throughout 2016 as OPEC members jawboned the market higher by talking about freezing or cutting production, which began when prices fell into the $20s in February.

jawboning

The strategy of verbal intervention led to greater ambiguity and increased anxiety in the market, allowing for sharp price movements. While OPEC members and its secretary general repeatedly say they seek market stability, their words and actions do the opposite.

impliedvolatility

Higher retail prices are also guaranteed. AAA reported Monday that pump prices rose for fourteen straight days. Overall, the average retail price was up 3 cents per gallon in the past week. While that may not appear all that substantial, more increases are likely to appear and the year-on-year surge of 20 cents per gallon is more significant. With OPEC now having announced cuts for 2017, there hasn’t been any more talk about $30-$40 oil, suggesting that even if OPEC can’t push prices much higher than current levels, the cartel has at least changed the narrative and kept the market from returning to levels that consumers enjoyed earlier in the year.

Cut to bring stability in the long run?

The outlook for next year has already shifted considerably as a result of the expected cuts. This week, the IEA says that if OPEC and non-OPEC producers go along with their pledges, the global oil market will swing from a surplus to a deficit in the first half of the year.

With upstream investment getting slammed for three straight years because of the weak market, Barkindo might have a valid point when he says that higher prices generated from the cut are needed for longer-term stability in the oil market. If forecasts from OPEC, the IEA, and the EIA are realized and oil demand continues to grow for the next two and a half decades, the supply side will need large-scale investment in order to keep up. But OPEC should simply let the free market sort this out instead of manipulating supply to get the price members want, since there is the chance the group’s cuts could cause the market to overshoot in the other direction. After the 1998-9 and 2008 cuts, the oil markets rallied significantly over the years, into triple-digit territory. To be fair, other factors such as rising oil demand and geopolitical instability supported prices during these bull runs, but OPEC helped create the conditions for sharp price spikes.

The outlook for next year has already shifted considerably as a result of the expected cuts. This week, the IEA says that if OPEC and non-OPEC producers go along with their pledges, the global oil market will swing from a surplus to a deficit in the first half of the year. This is in contrast to earlier forecasts saying that the surplus would persist throughout at least the first part of 2017, and perhaps the entire year.

But there’s a twist that could tighten the market even more. Saudi Arabia said that it is prepared to cut output more than expected, soon after Russia and other non-OPEC committed to pulling back on supply. “I can tell you with absolute certainty that effective January 1 we’re going to cut and cut substantially to be below the level that we have committed to on November 30,” Saudi Energy Minister Khalid al-Falih said after Saturday’s meeting. The Kingdom’s surprise announcement could be another example of verbal intervention on the part of the Saudis, simply boosting prices through rhetoric. At the same time, however, if they indeed follow through and cut more than their agreed share, the market could flip to a deficit that’s larger than anticipated, spurring greater volatility and more robust prices.

Consumers can take some solace that inventories are currently high and U.S. shale could respond fast. But given the unpredictability of the oil market, the OPEC/non-OPEC cut opens up many more scenarios, a number of which won’t benefit consumers.

It’s premature for Barkindo to say that OPEC’s cut is beneficial to consumers. So far, in just a couple of weeks since the deal, they’ve seen higher retail prices, more volatility, increased uncertainty, and a long list of oil-producing states coordinating to hold back supply to create an unfair market. Consumers can take some solace that inventories are currently high and U.S. shale could respond fast. But given the unpredictability of the oil market, the OPEC/non-OPEC cut opens up many more scenarios, a number of which won’t benefit consumers.

ADD A COMMENT