Daily Management Review

Why oil production cuts don’t guarantee rise in prices


When a shale revolution took place in the USA a few years ago and American oil companies entered the world market, the oil-producing countries realized that America was serious and it would be impossible to negotiate a reduction in production. This can primarily be explained by specifics of the American oil industry, which is a highly competitive market with numerous private companies that abide only market mechanisms.

If there is demand and production is profitable, they will produce, otherwise production will stop. In addition, low oil prices are beneficial to the entire US economy, as President Trump has repeatedly said, so that the country plans to increase production in the future.

In the new conditions, OPEC and non-cartel states agreed to regulate the balance of supply and demand on the world market artificially, by deliberately reducing oil production. In essence, a new informal oil price adjustment body, OPEC +, was created In December 2016. Reduction of production by 1.8 million barrels, upon which the oil powers then agreed, had a positive impact on the world market. The objectives pursued by the parties to the agreement have been achieved.

However, since the deal was concluded, oil production in Venezuela has dramatically dropped due to the political and economic crisis. Oil production in this country fell by about 1 million barrels per day. In anticipation of the introduction of an oil embargo, oil production in the Islamic Republic began to decline this year.

Thus, the first OPEC + agreement was exceeded by 1 million barrels per day, and its participants decided to redistribute the lost production between the countries starting from July 2018 with a view to further reducing production in Venezuela and Iran.

Meanwhile, the US oil industry continues to break records, reaching a production rate of 11.7 million barrels per day (as of the end of November). From the maximum of 2017, production increased by 1.6 million barrels per day.

With each report by the IEA and OPEC released this fall, forecasts for an increase in oil demand in 2019 grew worse. Against such a depressive background, the decision of the United States to exclude the eight main importers of Iranian oil from sanctions became a “footstep” for the oil prices, which fell immediately. Brent futures lost in the price of 33.7%, dropping from a four-year high of $ 86.74 per barrel to $ 57.5 per barrel.

All these factors contributed to the start of a new round of production regulation negotiations with a view to increasing quotes, thereby supporting production of shale oil in America. An alternative to reducing production would be to maintain the status quo. In this case, the price of oil would have dropped below cost-effective for American companies.

According to some estimates, which take into account all production costs, profit margins for American producers of shale oil should be $ 51 per barrel for Permian, $ 57 for Eagle Ford and $ 64 for Bakken, which is higher than the price of WTI crude at $ 50 a barrel before announcing production cuts.

Free cash flow of shale companies from the United States due to constant capital expenditure at a low price would not go out of the negative zone. High debt load would again trigger a wave of bankruptcies among oil companies aimed at increasing production at the expense of efficiency.

After reducing shale oil production in the United States, prices would go up again. However, this option is fraught with high risks for OPEC + and provokes frequent cyclical nature of quotations, to which American manufacturers would sooner or later adapt.
As a result, the United States has become a major market maker in the oil market. At the same time, the country is the largest producer and consumer of oil, its sanctions against Venezuela and Iran puts strong pressure on the investment climate and oil production in these countries. The US sanctions target two of the largest competitors in the oil market — Russia and Saudi Arabia — and the trade war with China stifles demand for energy.

The main levers of influence on the oil market are in the United States, and decisions made by OPEC + countries in terms of production volumes can be subsequently adjusted in Washington, if it considers that they disagree with its interests.

For example, it is now questionable to eliminate exemptions for eight importers of Iranian oil after the half-year period allotted. During 10 months in 2018, according to OPEC, production in Iran fell by an uncritical 13.5%. If there is such a strong and independent player on the market as the USA, the remaining oil-producing countries will need to meet every six months and adjust the production volume to maintain prices at a comfortable level for their budgets.

There is also a positive factor, and this is the limited growth of production in the United States. According to the baseline scenario of the Energy Information Administration (EIA), production in the country should reach a level of about 12 million bpd and stay near this value for two decades. But it must be borne in mind that with a significant reduction in cost due to operating and technological innovations in conditions of high prices, according to the optimistic scenario of EIA, oil production in the United States can soar to 14-15 million bpd in the 2020s and continue to grow.

Another alarming bell was announcement of Qatar’s withdrawal from OPEC from 2019. Most likely, this is a consequence of the growing influence of Saudi Arabia and Russia. The cartel membership becomes uninteresting for smaller states. Other countries may follow the example of Qatar, which threatens the effectiveness of the market regulatory mechanism.

source: forbes.com