OPEC’s Decision Will Balance The Oil Market

OPEC telegraphed its thinking for several months ahead of the cartel’s meeting last week in Vienna. All indications were that they would extend the production cuts they announced following last November’s meeting.

Following that November meeting, OPEC announced that it would reduce oil production by 1.2 million barrels per day (BPD) to address a global oversupply situation brought on by a combination of U.S. shale oil production and by OPEC itself. OPEC also announced that some major non-OPEC producers – most notably Russia – would cooperate with the production cuts, pushing the total amount of targeted cuts to 1.8 million BPD.

For several months, I have been predicting they would extend the cuts. In March I wrote in Forbes (see OPEC Is In A No-Win Situation) that an extension was the most likely course of action, rather than deeper cuts or abandonment of the strategy. 

So I was not at all surprised last week when OPEC, in cooperation with Russia and some other key non-OPEC members, announced it would extend the deal for production cuts by nine months to March 2018. As I have argued many times, I don’t believe they had much choice. The only real question in my mind was whether they would make additional cuts.

I only had a slight concern that OPEC could surprise everyone and abandon its strategy, in which case we might see a quick 20% drop in the price of oil. By maintaining the status quo, I think what we will see is a decent floor under oil prices, perhaps in the mid to upper $40s, and an upside to maybe $60/bbl as the cuts start to deplete global crude oil inventories. 

The market was at least somewhat disappointed that OPEC didn’t deepen the cuts, as oil prices dropped by 5% last Thursday following the announcement. In response, energy companies experienced a broad sell-off. But I don’t expect prices to remain depressed. OPEC’s decision is good news for U.S. oil and gas producers, but it seems like in the current market only great news will do.

So how should investors play this story? Over the next few months, we should see global crude oil inventories start to come down in earnest. U.S. crude oil inventories have fallen for seven straight weeks, and oil traders expect that larger declines are in store.

These declines are exactly what U.S. shale oil producers need. Falling inventories will provide support for oil prices, which will be good for the oil producers and the companies they depend upon, like oilfield services and sand providers.

The market came to its senses a bit on Friday with a small bounce from Thursday’s sell-off. I expect that in coming months we will see real progress on balancing the oil markets. The thing to watch is crude oil inventories. It is possible that shale production will come back so quickly that it negates much of the impact of the OPEC cuts, but crude oil demand is still forecast to grow by another 1.3 million BPD this year. It is highly unlikely that shale oil production will be able to negate both the production cuts and the demand growth, and that will show up in falling inventories.

As always, we will track these developments on an ongoing basis in The Energy Strategist. Consider subscribing for in-depth analysis and specific recommendations within the energy sector. 

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