Beginning of the end of the oil glut

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The focus of the week has been the meeting of the Organization of the Petroleum Exporting Countries (OPEC) members which took place in Vienna, Austria on Wednesday, 30 Nov 2016. For many months, Saudi Arabia, the largest oil producer in the OPEC group, has had ongoing negotiations with other OPEC members to convince them to agree to a production cut amid the oil supply glut and falling oil prices. On 22 Nov 2016, a week before the OPEC meeting, the market was confident that a deal to cut oil production would be imminent, sending West Texas Intermediate (WTI) crude futures to $48 USD a barrel, or over 5% jump from the closing price of the previous week ended 18 Nov 2016.

However, the deal looked shaky several days before the OPEC meeting, when Saudi Arabia cancelled a scheduled meeting with Russia and other non-OPEC members, sighting that it needed to resolve internal conflicts before discussing with non-members. Although Russia is not an OPEC member nation, it is the second largest oil producer in the world after Saudi Arabia.

A couple of days later, the Saudi oil minister, Khalid al-Falih, indicated that no production cut is required because demand will pick up in 2017 and OPEC intervention is not necessary. In addition, Iraq and Iran (second and third largest oil producers in OPEC) did not appear that they would agree to production cuts. Iraq contended that it needs the revenue from oil exports to fight the Islamic State (ISIS) and Iran wanted to increase oil production in an effort to regain market share after Western sanctions were lifted in January this year.

As the markets digested all the news, a deal to cut oil production seemed unlikely, sending the WTI crude futures down 4% to $45.23 USD a barrel, a day before the OPEC meeting. Energy producers around the world saw their share prices weaker as well. On 30 Nov 2016 (in Australia), the last trading day before the OPEC meeting, some of the largest oil and gas producers on the ASX, such as Woodside Petroleum [ASX:WPL], Oil Search [ASX:OSH] and Santos [ASX:STO], had their share prices fall around 5-7% during the week.

However, in a miraculous twist of events, the OPEC members did manage to reach an agreement to cut oil production, the first time in eight years. The group says it will cut oil production by 1.2 million barrels a day from January next year, working towards a daily production level of 32.5 million barrels. The news sent the oil price 9.3% higher to $49.44 USD, with the rally extending for the rest of the week, closing at $51.68 USD for the week ended 2 Dec 2016, a 12% weekly gain! Share prices in energy companies soared with the news, with Woodside Petroleum [ASX:WPL] and Origin Energy [ASX:ORG] hitting 52-week highs on 2 Dec 2016 before retreating as the broader Australian share market lost ground later that day (the S&P/ASX 200 closed 1.0% lower).

I really wonder if OPEC’s decision to cut oil production will have any lasting impact on oil prices. Back in 2014, when OPEC faced increasing threat from US shale oil producers, OPEC left production levels unchanged despite an oversupply in the market and falling oil prices. The theory was that falling oil prices would eventually put high-cost shale producers out of business while allowing OPEC nations (in particular, Saudi Arabia) to defend their market share. Although shale oil and other forms of unconventional oil and gas production have reduced significantly since then (with some producers actually going bankrupt), the shale industry probably proved more resilient than OPEC would have predicted. The flood of oil supply easily costed OPEC nations over a trillion dollars in forgone revenue over the last two years or so.

Any significant increase in oil prices will again make it attractive for surviving shale and unconventional oil producers to ramp up production, and OPEC nations will again lose market share like they did two years ago. If that happens, it will well and truly prove that OPEC has lost control of the global crude oil market, and free market will prevail with market supply and demand determining where oil prices should be.

If this is the beginning of the end of the crude oil supply glut, it could also spell the end of OPEC’s dominance over crude oil prices (and perhaps even the existence of OPEC itself).