OPEC Deal, What Does It Mean?

On the 29th of November 2016 a ‘game-changing’ deal was reached by OPEC to reduce the number of barrels per day of oil produced by 1.2m from January 2017. Adding to this last weekend Russia, a non-OPEC member, joined the deal and agreed to reduce their supply by 300,000 a day.

Why has a deal been made?

The purpose of the deal is to raise oil prices. Since the summer of 2014 oil plummeted from $110+ a barrel to $29 a barrel in January this year. As a result Saudi Arabia is running a monumental deficit of nearly 16% of GDP and other oil-producing nations such as Russia, Kazakhstan and Iran are itching for higher prices to help solve their fiscal issues.

Those who read my posts will know I am an OPEC-deal-skeptic. Russia has not been particularly co-operative over the past few years and Iran released a statement over the summer stating they should be producing nearly double the number of barrels/day than current levels. As a result I felt that this would mean more reliance on Saudi Arabia itself to cut supply, and thus give up part of its influence on the council. In the back of one’s mind we should also be aware that a deal has not been made between OPEC and non-OPEC members for 15 years. All of these factors still make me dubious of an immediate bull market in oil.

Oil price

Following the announcement of a deal on the 29th oil rose from just under $43 a barrel to $51 a barrel, see graph below. It fell slightly as the market questioned over reaction, before rising again over the week to $54 a barrel on the news that Russia would cut 300,000 a day.

screen-shot-2016-12-14-at-13-59-48-2

 

Stocks have faired quite well, with equities in energy rising +12.38% since a deal was announced, names such as Royal Dutch Shell are up 10.31%. Financials have also risen 10%, most notably because of their large balance sheet exposure to energy debt. Higher oil prices mean energy companies should become more profitable and be able to better service their debts, reducing the number of write-offs by banks.

However it is important to note that these two cyclical sectors are also benefiting from other factors, such as the Trump campaign pushing rhetoric on infrastructure spending, which implies inflation and thus higher interest rates. Greater infrastructure spending boosts energy stocks, because their products will be in higher demand, and higher interest rates improves bank yields and profits.

 

What happens next?

With oil settling around $52 I expect it may rise further to above $55 as supply cuts come into effect in January. However I do not expect Oil to breach $60. A key issue here is that $60 is an entry level for U.S. shale producers, tempting them to turn on their pumps, pushing supply up – and prices down. I am also dubious about the level of compliance from the oil producing nations. Russia has been known to agree to cuts only to then go ahead and increase supply. Considering they have just recently increased their production to their highest level in 30 years, at 11.21 million barrels/day, I feel they’ll be delighted to see higher prices and keep that production high.

At the end of the day this event doesn’t solve the main issue here, and that is why oil is so cheap in the first place. Yes, production has increased over the past few years – notably by Saudi Arabia to drive U.S. shale producers out of business, and Iran benefiting from reduced sanctions. But ultimately we are overlooking the demand side, maybe a persistent lack of global growth should be the focus here.

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