OPEC's Production Cuts: What it means for the market

Oil prices have been falling over the quarter. Will OPEC's production decision rebalance supply and demand?

Eric Espeseth, Senior Credit Analyst

On December 7th, the Organization of the Petroleum Exporting Countries (OPEC), along with key non-OPEC nations, announced the decision to lower overall oil production by 1.2 million barrels per day (mb/d). The cuts will begin in January 2019 and be based on production levels from October. The group, collectively known as OPEC+, has set an initial six-month period for the cuts with plans to review again in April 2019.

The OPEC+ production cuts are in response to a growing supply and demand imbalance in 2019, along with increased market volatility highlighted by the significant oil price sell-off which began in October. Recently, the International Energy Agency (IEA) has estimated excess supply will total 1.5 mb/d in 2019. This estimate assumed stable production levels from OPEC, meaning the recently announced cuts will go a long way toward balancing the market in the coming year.

The OPEC+ production cuts are positive for oil prices in the near-term, as they will help rebalance the market and should stabilize prices near current levels. We anticipate the cuts will effectively act as a floor on oil prices and reduce the risk for a further sharp decline in prices. However, the deal falls short of fully balancing global supply and demand.

We don't expect this supply reduction to lead to a meaningful rally in oil prices given remaining supply / demand concerns needing resolution over the medium-term. Weakening global economic growth fundamentals in 2019 are a primary risk weighing on oil demand. Additional factors impacting demand growth include trade and tariff uncertainty, the strong U.S. dollar and a general negative tone towards risk assets.

The risk for additional excess supply is led by continued strong production growth from U.S. shale producers and anticipated reduced takeaway constraints within the Permian Basin. Also impacting the supply outlook are the temporary sanction exemptions the U.S. government has granted to eight nations purchasing Iranian oil and execution risk for OPEC+ to adhere to set levels. The market will get some clarity on the OPEC+ compliance concern as the first post-cut production levels will be reported in February. Until then the market is likely to discount the overall benefit of the cuts, which will negatively weigh on oil prices.

Sources:

Bloomberg

OPEC press release, OPEC 175th Meeting Concludes, December 7, 2018.

OPEC press release, The 5th OPEC and non OPEC Ministerial Meeting Concludes, December 7, 2018.

Barclay's OPEC Recap, The Art of the OPEC Deal, December 7, 2018.