The effect of OPEC’s production cut on crude, propane prices

October 3, 2016 By and    
Photo: Foter

Image: Foter

Last week’s big news was the Organization of the Petroleum Exporting Countries’ (OPEC) decision to curb its production in an effort to support sagging crude prices. OPEC’s production ran 33.25 to 33.5 million barrels per day (bpd) in August, and it has agreed to cut it to 32.5 to 33 million bpd. The target is to cut 700,000 to 750,000 bpd from global crude supplies.

OPEC began to let the market know it was considering a production freeze or cut at the beginning of August, with crude on a steady downtrend and reaching a low of $39.26 on Aug. 2. Quickly following the announcement, crude prices began to climb, reaching a high of $48.75 on Aug. 19.

After that, doubts about a deal being completed crept into the market with West Texas Intermediate crude falling all the way to $42.55 on Sept. 20. Doubts about a deal continued all the way through Tuesday of last week as OPEC began meeting on the sidelines of the International Energy Forum in Algeria. Crude prices had rallied in the days prior to the meeting, but fell as it once again looked like a deal was not in the works. In fact, both Saudi Arabia and Iran said on Tuesday there would be no deal coming out of the meetings in Algeria.

Markets were shocked on Wednesday when OPEC announced it had agreed in principle to the cuts mentioned above. Crude prices that had hit a low of $44.40 on Tuesday rallied to a close of $47.05 on Wednesday and have continued going higher since then.

OPEC has not worked out the details of its production curbs in terms of what each country’s quota will be and how it will enforce the quotas. Those details are supposed to be hashed out by the completion of its regularly scheduled meeting in November. The plan to curb production is complicated by the fact that Iran, Nigeria and Libya will all be allowed to increase production, even as OPEC tries to meet the overall reduction in supplies. Iran insisted it must be allowed to increase its production to at least 4 million bpd. Currently, it produces 3.6 million bpd.

Nigerian and Libyan production is drastically below normal due to civil unrest. A return close to normal production could bring about 1.5 million bpd of crude onto global markets. Other OPEC countries may have to cut about 2 million bpd from their production to make room for this crude. We think it is obvious that most members of OPEC do not believe this production will be coming back anytime soon.

As always, the cuts will fall primarily on Saudi Arabia. Several members of OPEC, led by Venezuela, are in such dire straits financially there is no way they will cut production. They need to increase production and see a higher price just to avoid total financial collapse. Some of the other Gulf Arab countries will make token cuts to production, but OPEC’s top producer, Saudi Arabia, which currently produces 10.7 million bpd, will bare most of the sacrifice.

Why would Saudi Arabia, having worked so hard to increase production and gain market share since November 2014, be so willing to give it up? The kingdom is running a $100 billion-per-year budget deficit. Two-thirds of its population works for or is dependent on the government. Its budget is heavily dependent on oil revenues. It recently cut salaries of government workers by 20 percent.

Sources indicate that Saudi Arabia is going to drop its production by 500,000 bpd. The kingdom exports about 75 percent of its production. It is about to go into its season of low domestic consumption, so even with the production cuts, it will still have extra oil to export. It only needs to see a $2.35 per barrel increase in the price it receives for its exported oil to match revenues at its current production. So far, just the talk of a freeze has added $8 to the price of oil from where it was at the beginning of August. Goldman Sachs believes that if OPEC implements the cuts, crude could be another $7 to $10 higher in the first half of next year. The decision to cut production looks good for most OPEC members, at least in the short term.

The long-term benefits of cutting production are in question. The entire reason that OPEC, led by Saudi Arabia, implemented the strategy to maximize production to gain market share in November 2014 was to drive high-cost U.S. shale producers out of the market and take market share from them. U.S. production has declined by about 1 million bpd since OPEC implemented this strategy. However, OPEC miscalculated the resiliency of U.S. producers and the slowdown in the growth of global crude demand.

By now, OPEC expected that market forces, lower U.S. production and higher demand would have crude prices going up, even as it increased market share, recovering lost revenue and putting them in a sustainable market situation. However, crude dropped far more than OPEC anticipated and has stayed low far longer than it expected. Essentially, OPEC countries have suffered the most from trying to crush shale production.

The bottom line is that in the long run, it doesn’t matter what OPEC does. Any country dependent on crude revenues to support its government is going to have to tighten its belt and work to diversify its economy. As crude prices go up, higher-cost production from shale formations in the United States will increase and take market share from OPEC. No matter what decisions they make, OPEC countries will have to come to terms that revenue from crude will not return to what it was before the shale revolution.

Most OPEC countries have government budgets requiring crude prices at $80 to $120 per barrel. The new reality is those budgets are going to have to be adjusted to crude at $60 per barrel for the foreseeable future. OPEC is already getting benefits from its decision to curb production and will likely continue to do so for a while longer. But, from our seat, the long-term reality remains the same.

OPEC members are certainly savvy enough to know the long-term reality. It appears this move is designed more to stave off economic disaster as they work feverishly to diversify their economies and adjust government spending.

This move by OPEC will likely support higher crude prices and, thus, higher propane prices this winter, assuming propane fundamentals become reasonably supportive. That also assumes OPEC holds to its pledge to curb production and provides the necessary details of how that will be done in November. But, for now, we still think longer-term propane price forecasting should be done with the assumption of crude at $60 per barrel.

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