OPEC Cuts Strengthen Case for US Shale

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By now you have undoubtedly heard that late last month at OPEC’s 171st Ordinary Meeting in Vienna, the group announced that it would reduce output by about 1.2 million barrels per day (bpd) by January. This is the first announced output cut by the group in eight years. Saudi Arabia will bear ~40% of the cuts, with Iraq reducing output by nearly 20%. Nigeria and Libya were exempted from the cuts.

OPEC also secured agreements from non-OPEC members. Russia led this group of non-OPEC producers by agreeing in principle to cut production by about 300,000 bpd. Most of these non-OPEC cuts are symbolic, as many are in line with the natural production declines expected to be experienced by these countries.

The market response to the OPEC cuts was swift. Global prices for crude quickly jumped >10% to above $50/bbl. Shale oil producers surged across the board, with Continental Resources and Whiting Petroleum jumping 23% and 30% respectively.

Read New OPEC Production Limits Yield Winners — But Will They Last?

For those who have argued that OPEC is a paper tiger, I would ask what other organization has the power to move the price of oil so dramatically? They may sometimes behave like a paper tiger. But they are capable of rapidly moving the global oil markets. That is real market power.

I have seen some suggest that this agreement is much ado about nothing, on the basis of two (valid) points. The first is that OPEC members historically cheat on their quotas.

This is true, and some members are likely to cheat this time. But keep in mind the underlying theme. OPEC has now made a strategic shift after their costly decision two years ago to defend market share. In announcing these cuts, what they are really saying is they are tired of living with low oil prices. That’s a big deal, because it is a strategy they will likely pursue for several years. It is also being driven by Saudi Arabia, and they usually get what they want within OPEC.

While we may not get an accurate accounting of production in all OPEC countries, we will see the ongoing status of global crude oil inventories. We can gauge whether OPEC’s strategy is having success by whether crude oil inventories start to return to normal levels. And if they don’t start falling, expect to see more cuts.

The other valid point that is being made is that shale oil producers are likely to rush in and fill the gap from these cuts. This is certainly true to an extent. The question is to what extent they can do this. This isn’t like turning on the taps. It’s going to take some time to ramp up production. Meanwhile, OPEC will likely opt for more cuts should additional shale production negate their first round of cuts.

The total announced production cuts of OPEC and non-OPEC producers total about 1.8 million bpd. To fill that gap would require US producers to reverse the 1 million bpd decline that took place in the US over the past year, and add another 800,000 bpd. That may be doable, especially if oil prices surge much higher. But it will take time, and as time ticks away those sweet spots in the shale plays are depleting. US shale production will peak eventually, and OPEC may risk defending price while waiting for that to happen.

Read also The OPEC Deal: Here Are the Details

So it’s a gamble on OPEC’s side, just as deciding to defend market share two years ago was a gamble (which they lost). OPEC is likely betting that it can cut production more than the shale producers can increase production. If they had a crystal ball and knew US oil production could increase to 20 million bpd (as Continental Resources CEO Harold Hamm recently claimed), then it would be clear that it’s a fruitless exercise.

If, on the other hand, they end up cutting production by 2-3 million bpd and non-OPEC producers are unable to close that gap, then the gamble will pay off. But OPEC can afford to play the long game. They collectively produce 42% of the world’s oil. More importantly, they control 71% of the world’s oil reserves. They know global demand is forecast to continue growing.

Regardless of whether shale oil producers can make up for the cuts, this OPEC announcement is a big deal. It is a wave of the white flag by OPEC, and likely a strategy shift that will last for years. And it’s hard to see anything but upside from this move for America’s shale oil industry.

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