OPEC’s Preliminary Output Cut Deal: Hype and Skepticism – 10/7/16

The Organization of Petroleum Exporting Countries (OPEC) has agreed to outline a deal that could mean cutting production for the first time in eight years. Whether or not OPEC’s deal will impact oil prices in a meaningful way remains to be seen.

A global glut and price collapse in oil caused by a boom in U.S. shale drilling devastated economies of oil-dependent countries such as Russia and Saudi Arabia. But even as they instituted unprecedented austerity measures, OPEC nations shied away from output cuts in hopes that low prices would force high cost producers in the US to leave the market. The strategy has arguably been successful as US output has dropped, according to the EIA.

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That said, the relative cheapness and quick turnaround time for shale drilling, as well as the unexpected tenacity of surviving drillers, has led many to believe that shale will recover quickly. If OPEC attempts to prop prices with output cuts, then those drillers may return fast enough to put an effective ceiling on prices. The number of rigs targeting oil in the U.S. climbed to its highest level since February in the week ending on September 23, according to data from Baker Hughes Inc.

Also tempering expectations is the fact that the agreement was only possible because Iran will be exempt from capping production. Iran is one of the few OPEC countries not already pumping near record rates so their absence is notable. Previous talks have fallen through as Saudi Arabia, Iran’s rival in the Middle East and the largest oil producer in OPEC, refused to accept a deal that did not include concessions from Iran. Saudi Arabia’s change of heart demonstrates pain lower oil prices has brought to the nation as it faces a record budget deficit this year.

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Still, OPEC won’t decide on targets for each country until its next meeting at the end of November and must also convince others, especially Russia which has cheated in past deals with OPEC, to cap their own output. Russia was pumping at an all time high of 11.1 million barrels a day in September. With over 60% of world production outside OPEC member countries, concerns about maintaining market share could sink the final deal before it has a chance to float.

For its part, Russia will assume an average price of $40 a barrel in the next three years even after the preliminary agreement by OPEC, according to Finance Minister Anton Siluanov.

“You think it’s stabilized?” Siluanov said. “We need to see how realistically the decisions will be implemented.”

Goldman Sachs Group Inc. and Morgan Stanley have also expressed skepticism that the deal can be completed.

The deal may have already moved the price of oil by 5%, but such movement has been common in this unusually volatile year so it would best to not get too excited.

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