By Cary Springfield, International Banker
On April 2, a surprise cut to crude-oil production was announced by the OPEC+ group, which includes the 13 members of the Organization of the Petroleum Exporting Countries alongside 10 additional major oil producers, such as Russia and Mexico. The group announced the 1.16-million barrel-per-day (bpd) cut just a day before it was scheduled to meet. It will be in effect from May until the end of 2023. As such, it represents yet another shock to global oil markets and continues to fly in the face of the desires of high-consumption countries, such as the United States, for lower prices amidst an ongoing battle against elevated inflation.
Saudi Arabia’s Ministry of Energy described the cut as “a precautionary measure aimed at supporting the stability of the oil market”, with the Kingdom itself leading the way by slashing its own output by 500,000 bpd. Iraq, the United Arab Emirates (UAE) and Kuwait were the other group members to announce significant cuts of 211,000 bpd, 144,000 bpd and 128,000 bpd, respectively. Not surprisingly, the announcement triggered an immediate spike in global oil prices, with the benchmark North Sea Brent Crude grade jumping by $5 to $85 per barrel (/bbl) and entirely reversing the sell-off in March, which saw prices fall to their lowest level since December 2021 as fears mounted over a looming banking crisis and likely recession.
And with this cut following the massive two-million-bpd cut—around 2 percent of global supply—that OPEC+ announced in October 2022, sending shockwaves across financial markets, it is worth examining the motivations for such dramatic measures. On that occasion, the group of oil-producing nations justified the curtailment as necessary to counter rising interest rates in the West and the weakening global economy. But the move drew considerable ire from Washington, which has been keen to see lower prices as it continues its attempts to bring inflation down to the Federal Reserve’s (the Fed’s) target of around 2 percent. Western countries also aim to prevent Russia from enjoying oil-revenue gains in the face of hefty sanctions packages implemented against Moscow since it invaded Ukraine in February 2022.
Indeed, the prevailing view from the US following the October cuts was that OPEC was siding with Russia and helping it counter the sanctions through higher oil revenues. “The President is disappointed by the shortsighted decision by OPEC+ to cut production quotas while the global economy is dealing with the continued negative impact of Putin’s invasion of Ukraine,” the White House stated. Since then, the United States Congress has decided to consider legislation enabling the seizure of OPEC’s assets on US territory should such collusion be proven.
It also prompted President Joe Biden’s administration to initiate a massive oil sale from its Strategic Petroleum Reserve (SPR), an emergency crude stockpile the US created following the 1973 Arab oil embargo, of 15 million barrels. With around 180 million barrels sold during the year, the SPR sits at its lowest level in 40 years. And although the US had pledged to buy back oil to refill the SPR at a target price of $67-$72/bbl for the US benchmark WTI (West Texas Intermediate) – Cushing, Oklahoma grade, this has not materialised thus far.
According to Reuters, moreover, J.P. Morgan and Goldman Sachs claimed the US decision not to buy back oil for reserves “might have contributed to the move to cut output” by OPEC+ in early April. Indeed, the group criticised the International Energy Agency (IEA)—widely considered a key energy agency of the West, with the US its biggest financial donor—for releasing oil stocks last year, a move the oil group says was politically motivated and designed to help embattled US President Joe Biden.
Nonetheless, the US has again taken a dim view of OPEC+’s fresh round of production cuts. “We don’t think cuts are advisable at this moment given market uncertainty—and we’ve made that clear,” a spokesperson for the National Security Council (NSC) said. To compound matters, Russia also confirmed on the same day that it would extend its voluntary production cut of 500,000 bpd until the end of this year. The cuts were first announced in February in response to the implementation of Western price caps on Russian oil exports—or what the Russian deputy prime minister, Alexander Novak, described as “interference with market dynamics”.
At 5 percent for March, the inflation monster is yet to be slain, which, in turn, largely explains the US’ continued disappointment with the OPEC+ cuts. And while the Federal Reserve may prefer to focus on core inflation—a measure of prices that strips out the typically volatile energy and food components—persistently high oil prices can end up impacting core prices through other mechanisms, such as higher raw-material costs. “The Fed sees OPEC decisions as mostly geopolitical, but they can impact production of goods and the transportation of other items, so those higher oil prices can bleed into that core component, which the Fed does tend to focus on a little bit more in terms of setting policy,” Sarah House, senior economist at Wells Fargo, told CNN.
But the Saudi-led group could also have implemented the output cuts to punish excessive speculation, particularly those short sellers betting on a sizeable drop in crude prices. Speaking to unnamed people familiar with the matter, Bloomberg reported on April 3 that OPEC+ began to recognise a policy change was required on March 20 when the Brent Crude price fell to a 15-month low of around $70/bbl, as fears over banking turmoil and an economic downturn led to the amassing of significant short positions. As such, the Saudis felt that short sellers “were due a reminder of the pain OPEC+ can still inflict on them”, a sentiment the Kingdom has expressed since at least 2020 when its minister of energy, Prince Abdulaziz bin Salman Al Saud, said that he wanted “the guys in the trading floors to be as jumpy as possible” and promised to “make sure whoever gambles on this market will be ouching like hell”.
And indeed, short sellers were significantly squeezed following OPEC+’s surprise production-cut announcement, with Reuters showing that money managers bought the equivalent of 128 million barrels in the most important petroleum futures and options contracts in the week to April 4—the fastest rate in more than three years. Remarking on the “Commitments of Traders” report (issued by the Commodity Futures Trading Commission [CFTC]) for the same seven-day period, Saxo Bank also noted that the OPEC cuts had triggered the “biggest buying spree since 2016”. Reuters’s calculations, meanwhile, showed that bearish positions for the week were reduced to the lowest level for 11 weeks since late January, while ICE (Intercontinental Exchange, Inc.) Futures Europe data revealed that fund managers slashed their short positions in Brent Crude by 29,118 contracts, the sharpest drop since 2020 and the biggest in at least 12 years in percentage terms.
Could recent historical events have also played a role in informing OPEC+’s decision to slash output? The Global Financial Crisis (GFC) triggered a monumental oil-price crash, from around $140/bbl to $35/bbl during the latter half of 2008 amidst a sharply deteriorating economic environment. “They’re looking into the second half of this year and deciding they don’t want to relive 2008,” Bob McNally, president of Rapidan Energy Group, explained to CNBC, adding that oil prices could even “make a dash for $100…if Chinese demand goes back to 16 million barrels a day second half of this year [and] if Russian supply starts to go off because of sanctions and so forth…. Then these cuts, if they stick with them, are going to super tighten the market.”
Indeed, the new cuts may push oil prices into the three-figure territory, given their likely impacts on further widening the existing global supply deficit, with some analysts even suggesting that this latest cut will be more impactful than the nominally larger cut OPEC+ announced in October. “Most of the cuts will be made by countries that are producing at or above quotas, which implies a higher share of the announced cuts will translate into real supply reductions than in October 2022,” Energy Aspects’ founder, Amrita Sen, who expects prices to hit $100 per barrel, recently told CNBC.
That said, higher prices could catalyse prolonged monetary-tightening policies from the Fed and other leading central banks, dampening global demand and remaining a persistent drag on oil prices throughout 2023. “The development comes as a blow for inflation,” Sophie Lund-Yates, lead equity analyst at Hargreaves Lansdown, noted following the announcement of the cuts. “Markets are aware that if the pressure continues, central banks will need to extend or strengthen their interest rate hiking cycles.”