Why OPEC’s attempt at cartelisation may not work this time

Organisation of Petroleum Exporting Countries (OPEC) has surprised the oil market by announcing a production cut. Oil markets in the US shot up on this announcement as there were no expectations of a deal among major market participants.

However, the rally fizzled out by the time Asian markets opened with oil prices consolidating as the market had time to digest the news.

So where is the oil market headed and how important is this production cut announcement?

The very fact that OPEC members agreed on the cut is seen by many as an important development. This is the first time since 2008 that oil production is expected to be cut. The announcement is seen as a policy shift where OPEC has once again decided to control oil price. But will it be effective in doing so and moreover is the production cut sizeable enough?

Reaction of Asian markets and commentary by various analysts suggests that not many believe OPEC will be able to maintain the discipline needed to cut oil production. Even before sitting for the meeting, most of the OPEC countries were producing oil way above their previous quarter average. Jay Hatfield, a portfolio manager at Infracap MLP Fund in New York said that it’s like they are agreeing to nothing, equating the small cuts proposed to taking their collective foot off the gas pedal instead of stepping on the brake.

Lack of details from the deal is adding to the passive response. The only announcement coming out of the meeting was that OPEC will cut its production by 700,000 barrels a day which will bring down its production rate from 33.2 barrels to between 32.5 – 33 barrels. Apart from the numbers not adding up, the other issue where analysts are seeking clarity – who will be willing to cut production?

In the previous cut announced by OPEC, apart from Saudi Arabia none of the other countries were following the mandated production levels. The apprehension is justified to some extent as few are expected to follow it this time around, especially since all OPEC member countries are going through one of their worst economic crisis in recent times.

Even if the countries follow the discipline of cutting production, oil market has expanded well beyond OPEC’s control. Global oil production stood at around 50 million barrels per day in 1974, with OPEC contributing over 25 million barrels. But now world production is very close to 100 million barrels per day while OPEC’s own share has only risen to 33 million barrels.

Further, new players, especially shale oil producers in the US are waiting for an opportunity to jack up their production to take advantage of the price rise.

Goldman Sachs in a note on the development said that it is holding on to its forecast of $43 a barrel for the end of this year and $53 a barrel in 2017. ‘If this proposed cut is strictly enforced and supports prices, we would expect it to prove self-defeating in the medium term with a large drilling response around the world.’

-Shishir Asthana

This article was published in Business Standard. Click here

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