OPEC and key partners opted for a middle path coming out of the 175thmeeting of the OPEC Conference, agreeing to cut oil production by 1.2million barrels per day (bbl/d) from October levels (an even steeper cutthan versus November levels). We expect the move to support prices in thelow $60s/bbl for Brent crude and in the mid-$50s for WTI.
We believe the production cuts are prudent and represent a “third way” toaddress market concerns that seeks to avoid some of the negative outcomesof recent moves. In 2014, OPEC elected to pursue a policy of market sharerather than output cuts, which led to a collapse in oil prices; in 2016, incoordination with several non-OPEC producers, the cartel reversed courseand cut output, spurring a gradual doubling of prices. This year’s OPECagreement seeks to limit the market imbalance and stem the recent pricedecline while not driving prices substantially higher – a move that moreclosely resembles behavior prior to 2014.
How we got here: evolution of the oil market in 2018
Oil prices had been on a steady upward trajectory after the U.S. exited theIran nuclear deal (Joint Comprehensive Plan of Action, or JCPOA) in May, aided by the previous period of OPEC output restraint. In June,partly in response to the U.S. renewal of sanctions on Iran and to offsetdeclines in other producers, such as Venezuela, OPEC reversed course andbegan opening the spigots. This helped push output to new record highs inOctober and November.
In anOctober blog post, we cautioned that oil had run ahead of fundamentals and that a release ofwaivers for Iran oil consumers could cause prices to retrace back to themid-$70s – effectively erasing some of the geopolitical risk premium thathad entered the market. Fast-forward two months, and oil had fallenprecipitously, well below the 70s, and the granting of waivers wasinsufficient to explain the drop. A surge in U.S. supply, which has grownby nearly 3 million b/d annualized over the past three months, was theprimary cause. In August and September, U.S. output was between400,000–500,000 bbl/d above International Energy Agency (IEA) and consensusprojections. The surge was particularly notable given concerns aboutpipeline constraints. In effect, both the U.S. and core OPEC producers eachmanaged to replace any decline in Iranian exports, allowing inventories tobuild.
This output jump coincided with a deceleration in global demand growthowing both to temporary factors (such as low water levels in the RhineRiver that disrupted transport, leading to internal stock draws) and macroissues, including a continued decline in global manufacturing purchasingmanagers’ indexes (PMIs). Falling petrochemical demand, which coincidedwith the drop in global automobile manufacturing, had a particularlymeaningful impact on the light ends of the barrel (i.e., liquefiedpetroleum gases, such as propane and butane).
OPEC’s ‘third way’ sidesteps key risks
Against this backdrop, OPEC faced a particularly thorny challenge: Cuttingtoo much and supporting prices at too high a level would risk curbingdemand and supporting U.S. production expansion; and reverting to a marketshare war would risk another price collapse, with the attendant collateraldamage to producing economies.
OPEC opted for a third way: Cutting enough to prevent notable storagebuilds, while at the same time supporting prices at levels that should slowU.S.-driven investment. The cut was below what the Joint OPEC-Non-OPEC Ministerial MonitoringCommittee (JMMC) had suggested was necessary to rebalance the market,potentially leaving oil bulls disappointed. However, with prices below$45/bbl in many onshore U.S. producing basins, a deceleration in U.S.production growth should help achieve this ultimate goal. In addition,lower prices should give demand a shot in the arm. Given the lower pricesand rebuilding inventories, we would also expect the U.S. to be aggressivein pressuring Iranian exports heading into the second quarter of 2019, whenthe current waivers are set to expire.
On net, we believe OPEC’s policy coming out of the December meeting shouldsupport oil prices in the low $60s for Brent crude and the mid-$50s forWTI. Downside risks could stem from greater-than-expected economicdeceleration. On the upside, a reignition of the global manufacturing chainwould go a long way toward supporting demand and market sentiment.
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