Why OPEC+ cut oil production: 6 things investors need to know

The Organization of the Petroleum Exporting Countries and its allies said they decided Sunday to cut production in an effort to support oil-market stability, but that offers little comfort to consumers worried about inflation and an expected spike in fuel demand during the coming summer driving season. 

The surprise output reduction by the group known as OPEC+ starting in May also comes at a particularly vulnerable time for the U.S., which may not be able to quickly increase its own production. “The nature and timing of the decision are shocking, since prices have been only moderate pressured from the banking mini-crisis and the market is expected to tighten later this year,” said Michael Lynch, president of Strategic Energy & Economic Research. “OPEC+, and especially the Saudis, seem to be signaling a strong desire to punish short sellers and pre-empt possible demand weakness,” he told MarketWatch. Also, “the impact on inflation…could mean an anemic summer driving season.”What happened? OPEC and its allies, a group known as OPEC+, announced voluntary production “adjustments” on Sunday that will take effect starting in May and run through to the end of the year. 

The move was unusual, as there was no indication that any change to production would be made and OPEC+ ministers weren’t scheduled to officially hold an output decision-making meeting until June 4. The OPEC+ Joint Ministerial Monitoring Committee, however, did hold a meeting on Monday, as it does every two months. The committee has no ability to make decisions on production, but has the authority to request an OPEC and non-OPEC ministerial meeting at any time to address market developments. The JMMC had been expected to discuss a number of oil-market issues, and confirm that previously announced cuts of 2 million barrels a day would remain in effect. The committee on Monday indeed reaffirmed its commitment to that previous agreement, but also pointed out Sunday’s announcement. “Unlike cuts in the past that were more ‘paper cuts’ to quotas with many countries already producing below quota, these are real voluntary cuts from countries producing at or above quotas,” said Rebecca Babin, senior energy trader at CIBC Private Wealth U.S., in emailed commentary. That means this will be “far more impactful than the 2 million barrels cut” announced in October 2022. Saudi Arabia will take on the biggest reduction, cutting oil output by 500,000 barrels a day. Other barrel-per-day cuts include Iraq with 211,000, United Arab Emirates 144,000, Kuwait 128,000, Kazakhstan 78,000, Algeria 48,000, Oman 40,000 and Gabon 8,000. Those total 1.157 million barrels a day.

 The cuts, however, are in addition to the previous OPEC+ production cuts of 2 million barrels a day, as well as the extension of Russia’s reduction of 500,000 barrels a day in retaliation to western oil-price caps and sanctions. That brings the total output reductions to 3.657 million barrels a day.What prompted the cut? Saudi Arabia’s Ministry of Energy on Sunday, as well as the JMMC in a statement Monday, said that the cuts are a “precautionary measure aimed at supporting the stability of the oil market.” Some news reports and analysts have speculated that Saudi Arabia, a member of OPEC and among the world’s top oil producers, and other major oil producers made the surprise move to cut output because of recent comments made by U.S. Energy Secretary Jennifer Granholm. Read: Trigger for Saudi oil production move was comment that U.S. would not refill SPR this year, report says On March 23, Granholm said that it may take years for the U.S. to refill its Strategic Petroleum Reserve. She appeared to walk back those comments on March 28, with Reuters reporting that she said the U.S. could start buying back crude oil for the SPR late this year. The Biden administration last year announced the emergency sale of 180 million barrels of SPR crude to help lower gasoline prices, and has said it would refill the reserve when oil prices fell to around $70 a barrel. U.S. benchmark West Texas Intermediate crude oil fell below $70 a barrel to their lowest level in 15 months on March 21. Why was the market so surprised? The OPEC+ decision took the financial market by surprise. “If fully delivered, the announced cut would further tighten an already fundamentally tight oil market, driving the Brent benchmark towards $100 per barrel sooner than previously expected, and would push the price to around $110 per barrel this summer,” said Jorge Leon, senior vice president at Rystad Energy. Before the new OPEC+ cuts, Rystad Energy was anticipating the crude-oil market to be in a supply deficit to the “tune of 1.4 million” barrels a day between May and August, he said in emailed commentary. 

The voluntary cuts will put “upside pressure on prices from a fundamentals perspective, offering support of around $10 per barrel.” On Monday, the front-month May WTI oil futures contract CLK23, +6.28% CL.1, +6.28% climbed 6.4% to trade above $80.50 a barrel ahead of the closing bell on the New York Mercantile Exchange. Global benchmark June Brent oil BRNM23, -0.08% BRN00, -0.08% rose $4.75, or 6.3%, to close at $80.42 a barrel on ICE Futures Europe. “Positioning in crude is extremely light after the recent financial market driven weakness,” said Babin. Last week’s rally was driven primarily by short covering and modest re-engagement from long buyers,” she said, adding that the long position, or bets that oil will rise in value, is “very modest, with the managed money long-short ratio at 2.5, the lowest since December 2022.” Large short positions held by speculative traders can make for more explosive rallies as “weak-handed” players are forced to buy futures to close out losing trades. Craig Golinowski, managing partner at Carbon Infrastructure Partners, also pointed out to MarketWatch that paper market for oil is “very thin.” Fewer participants and financial flows have created downside pressure on oil, he said, so OPEC is “physically managing production to maintain a tight market to ensure investment into production remains stable, regardless of the paper market for oil.” The energy market saw broad gains, with company shares and exchange-traded funds, including the Energy Select Sector SPDR Fund XLE, +5.07%, rallying in the wake of the OPEC+ news. St. Louis Federal Reserve President James Bullard on Monday said the spike in oil prices after the OPEC+ cut announcement may make the central bank’s inflation-fighting job “a little more difficult,” though it is too soon to know for sure. The latest spike in oil prices may “play a hand in what the Fed does next regarding its fight against inflation,” particularly if the latest jump in oil is sustained as oil at the current level “won’t be doing the inflation rate any favors,” said Tim Waterer, chief market analyst at Kohle Capital Markets. Read: Oil-production cuts could force Fed to raise interest rates even higher to fight inflationWill OPEC+ lose market share? In the past, OPEC+ has been concerned about the loss of oil-market share when it decides to make production cuts. This time, however, there is “limited threat to market share,” said CIBC Private Wealth’s Babin. Previously, when OPEC+ cut production, they would lose market share to U.S. shale oil producers, she said. “However, “U.S. shale producers have entered a period where growth is limited due to financial discipline.”

 Recent developments in regional banks has “likely lowered shale producers’ ability to quickly get capital to increase production,” said Babin. Total U.S. petroleum production stood at 12.2 million barrels a day as of the week ended March 24, down 100,000 barrels per day from a week earlier, according to data from the Energy Information Administration. OPEC would usually “hesitate to reduce barrels, with fears of ceding market share to U.S. shale, but the slowing of U.S. production and their dedication to a disciplined approach has alleviated the Saudi’s fear of rapid U.S. growth,” said Alex Hodes, energy analyst at StoneX.What are the geopolitical implications? Meanwhile, James Swanston, Middle East and North Africa economist at Capital Economics, in a note said the OPEC+ move was likely motivated by geopolitics and Saudi Arabia’s “shift away from the West.” Saudi Arabia’s ties with the U.S. are “fraying,” he said. Swanston also said the production decision has implications for the future of OPEC+ oil policy, as well as the “patience of members, particularly, the UAE.” The U.A.E. agreed to these voluntary output cuts, but it was reported last month that officials were growing impatient at the bearish OPEC+ stance and had discussed internally whether to leave the group, said Swanston. The Wall Street Journal: Saudi Arabia and U.A.E. Clash Over Oil, Yemen as Rift Grows The U.A.E. wants to “increase oil output sooner rather than later as shown by its move to bring forward its oil production capacity target from 3.1 [million barrels per day] currently to 5 million bpd by 2027,” instead of the year 2030, said Swanston. 

He said the U.A.E. had twice previously threatened to leave OPEC+ and that there was speculation that the U.A.E. was strongly against the Saudi-led decision to cut OPEC+ oil output quotas by 2 million bpd in October. “If the OPEC+ strategy of lower oil production persists, then tensions could escalate, and the U.A.E. could ultimately opt to leave OPEC+,” Swanston said. What do the cuts say about demand? The production cuts will take effect in May, which is “right ahead of Memorial Day and the start of U.S. driving season,” said Stacey Morris, head of energy research with VettaFi. Given that, “it could be another summer with painful prices at the [gasoline] pump,” she said. The average price for regular unleaded gasoline stood at $3.506 a gallon on Monday, up from $3.439 a week ago, but down from $4.192 a year ago, according to AAA. Read: The surprise OPEC+ oil production cuts will increase gas prices — here’s how much Still, some traders may interpret the OPEC+ cut as a sign of weaker than expected demand for physical markets, given that OPEC+ possesses “some of the best information available in regards to the global physical oil markets,” said Rob Thummel, portfolio manager at Tortoise. However, “ we still expect global oil demand to accelerate throughout 2023, reaching a record high in the second half the year,” he said. Global oil inventories are below normal and will likely “remain below normal as higher demand and less supply deplete inventories throughout the year,” Thummel said, noting that Tortoise expects oil prices to be range bound between $85 and $95 for the year. 

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