OPEC No Longer Controls The Oil Game

At the bi-annual meeting in Vienna last week, the Organization of Petroleum Exporting Countries (OPEC) announced its decision to extend the production cut of 1.8 million barrels of oil per day until the first quarter of 2018 to support the recovery in oil prices. While the market had anticipated the move, the extension did not have a strong impact on crude oil prices, unlike the surge in commodity prices witnessed in November 2016 when the OPEC deal was first announced. To put things in perspective, WTI crude oil prices had gone up by more than 9% in November post the agreement of output reduction by the oil cartel, as opposed to only a 2% jump in oil prices when the OPEC announced the extension of the cuts. This trend not only indicates that the proposed output restrictions are insufficient to have a meaningful impact on oil prices, but also hints at the fact that the OPEC has finally lost its power to influence crude oil prices.

Data Source: US Energy Information Administration (EIA)

Changing Position Of The OPEC In The Oil Markets

Historically, the OPEC accounted for more than 40% of the world’s crude oil production, and was responsible for exporting nearly 60% of the total petroleum traded internationally. Consequently, the cartel’s huge spare capacity that could be easily maneuvered to suit the condition in the global oil markets, coupled with its significantly low cost of production, allowed it to play the role of a Swing Producer, exerting a strong influence on crude oil prices.

However, things changed for the worse when the oil prices crashed in mid-2014 due to the oversupply created by the US shale producers. At first, the OPEC decided to keep pumping high levels of oil, despite the plummeting prices, to defend its share in the global oil markets. Until mid-2016, this strategy seemed to work well for the member countries as they could easily sustain their oil output even at a price of $30 per barrel. That said, the prolonged weakness in oil prices started weighing heavily on the OPEC members and their economies which are highly dependent on oil exports. Thus, the cartel members, who had earlier decided to take an aggressive approach to push the US shale producers out of business, were forced to pull back their output to boost oil prices, and in turn stimulate their dwindling economies. 

Source: US EIA Website

US – Rising Production & Declining Break-Even Price

The boom in the shale oil production in the US was one of the key reasons behind the sudden fall of the commodity markets in 2014. However, the high marginal cost of production made it economically unviable for most of the US shale producers to operate in the weak oil price environment. Consequently, a number of shale companies had to file for bankruptcy, while the others were forced to reduce their output to sustain their operations in the last couple of years. That said, the US producers continued to invest in building new and innovative technologies that would enhance their operational and capital efficiency. As a result, these producers have managed to produce more oil with fewer rigs, due to the use of longer laterals, and more pressure pumping, bringing down their break-even oil price from over $80 per barrel in 2014 to $50-$60 per barrel at present.

Since oil prices became sticky in the $50-$55 per barrel range in the 1Q’17 driven by the OPEC production cuts, the US shale producers reinstated their drilling and exploration plans. This was evident from the notable rise in the global rig count (oil as well as gas) from 1,678 units at the end of November 2016, to 1,917 units at the end of April 2017. In line with the increased drilling, the US oil production also went up from 8.7 million barrels of oil per day (Mbpd) at the time of the announcement of the OPEC deal to 9.3 Mbpd at present. Thus, it would not be incorrect to say that the US shale producers have not only wiped out the impact of the OPEC production pull-back, but have also displaced the importance of the OPEC in the oil price equation.

Data Source: US EIA; Baker Hughes Rig Count

China – The Crucial Demand Driver

At the time when the commodity markets were busy anticipating the OPEC’s extension and the possible response of the US shale producers to this news, Moody’s Investors Service downgraded China’s credit rating from A1 to Aa3, just a day prior to the OPEC meeting. The rating agency’s decision was driven by the fear of the ballooning debt in the Chinese economy and the government’s expected efforts to pump up its economy with higher spending levels. The move is being viewed as a warning bell by the investors, since it is the first credit downgrade for China in nearly three decades, and is suggestive that the country’s exponential economic growth is expected to finally slow down.

Given that China is the world’s largest consumer and importer of oil, it was expected to drive more than one-third of the global demand for oil in 2017 and beyond. In fact, the International Energy Agency (IEA) expects the Chinese oil demand to expand by 400,000 barrels per day to 12.3 Mbpd in the current fiscal year. Since the OPEC has extended its production cuts until 1Q’18, China’s oil demand is the single most important variable that can ensure the re-balancing of oil markets from the demand point of view. However, a slowdown in the Chinese economy, as suggested by the recent credit downgrade, is likely to pull down the country’s demand for oil, and could prove to be detrimental for the already depressed oil prices.

See Our Forecast Model For Crude Oil Prices Here

In addition to this, China has been increasing its oil inventories rigorously over the last few quarters. As per the latest data, the country’s crude oil imports surged to an all-time high of 9.2 Mbpd in March of this year. This is remarkably higher from China’s stockpile of 8.3 Mbpd in the previous month. At these levels, China has become the world’s top crude oil importer in this year so far. This is largely because the country has allowed a number of newly qualified independent refiners to purchase oil from the international markets. While the market expects these inventory levels to drop in the coming months as the Chinese refineries shut down for maintenance in the second quarter, the industry experts believe that the lion’s share of the oil glut over the last couple of years has been absorbed by China in the form of strategic petroleum reserve (SPR).

Even if we assume that the Chinese economy will continue to grow at its current rate (despite the downgrade), the country’s demand is likely to be met with these high inventory levels that were purchased at significantly lower oil prices. This could slow down the global oil demand, increasing the gap between the demand and supply of oil in the global market, and pulling down the oil prices further.

Source: Zerohedge.com; Scotiabank Economics

In the light of the above discussion, we believe that despite contributing a large portion of the global oil supply, the OPEC has lost its power to dictate the direction of the oil prices. Instead, the US shale supply and the growth in the Chinese economy have become the key drivers of crude oil prices.

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