Opec supply cut: how will it impact oil prices?

Is oil heading for a century, AGAIN?

What do plastics, clothing, fertilizers, perfumes, paints, tyres, medicines, etc. have in common? They are all made using crude oil or products derived from oil. Because of its wide-ranging use, oil is one of the most important global commodities and critical to economic well-being. So when the oil price rises or falls, the world notices. 

Price of oil like any other commodity is impacted by its demand and supply. Following a major announcement last weekend, oil prices are set to rise and may even cross the $100 mark. 

OPEC surprised global markets last weekend when it announced a sharp cut in oil output levels, by about 1.16 million barrels per day (mnbpd). The cuts are to start from May till the end of 2023. This cut came after the already agreed-upon cut of 2 mnbpd for 2023, taking the total volume of cuts by OPEC+ to 3.66 mnbpd, which is equal to 3.7% of global demand. This reduction in oil supply is expected to push oil prices. 

The cartel has once again proved that it has tremendous power in the energy markets and can dictate terms around the world. 

Who is the OPEC and why do they enjoy so much power?

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Opec and its pricing power

Founded in 1960, OPEC, or Organization of the Petroleum Exporting Countries, was initially a consortium of 13 oil-producing countries with 80% of the world’s oil reserves that came together to secure cooperation between oil-rich countries. Another 10 major oil-producing countries including Russia later aligned with the group to form OPEC+. 

The group controls about 40% of the global oil supply and makes up for 60% of the global petroleum trade. Thus, these countries have enormous power to regulate global oil prices by way of a collective reduction or increase in oil production. But of course, the organization’s influence is very rarely welcomed by non-OPEC+ countries that rely on their oil, especially the US.

So, OPEC has several times collectively announced changes in oil production levels to control oil prices. Why then were major economists surprised by its latest move?

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Why so surprised?

Saudi Arabia, the top OPEC producer, has pledged to cut output by 500,000 barrels per day, while other countries such as the UAE, Kuwait, and Iraq have also committed to reducing their production levels.

The surprise production cut comes after the group had announced no further cuts when it last met in February 2023, and the markets were expecting a similar decision from the group in April as well. 

However, since the last meeting, the world saw several banks collapse. Concerns that the banking crisis may spill to other sectors along with fears of recession weighed on oil prices. 

But these fears had quickly abated and oil prices had already recovered from their low levels. Benchmark Brent crude had touched a low of $73 in mid-March’23 but had already recovered back to $80 levels. 

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But why the cuts?

There are three likely reasons why OPEC+ went on with this decision: 

1. Protection of profits – Cutting production will limit the supply resulting in increased prices as the demand is more than the supply. Oil prices had fallen below $85 from the peak of $122 in June. This decision can boost the prices.

2. Global uncertainty – The group said the decision was based on the “uncertainty that surrounded the global economy and oil market outlook”. Several bank collapses last month have heightened uncertainty and caused the oil price to collapse to $73 levels. This is very close to the breakeven price of $65 at which Saudi Arabia’s budget balances. China’s post-Covid demand recovery is also yet to pick up, further denting oil demand. So this decision was a precautionary measure to provide more stability to the energy market.

3. Reply to USA sanctions – Russia is using this move as an answer to the various sanctions imposed on them by the USA.
   

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Back to square one

The US has opposed the move, claiming that lower prices are necessary to prevent a recession-like scenario as well as stop Russia from increasing its oil income to finance the Ukraine conflict. Goldman Sachs is expecting oil prices to rise to $95 by end of December’23 and to hit the century in 2024.  

Higher oil prices are going to further complicate the high inflation problem that central bankers around the world are grappling with. The production cut will happen from May till the end of the year, but analysts are predicting that the real effect of this supply crunch will come during the latter half of the year when Chinese demand will recover. 

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A divided East and West

This production cut comes amidst many other geopolitical events like Saudi Arabia partnering with China to build a $12.2 billion oil refinery, agreeing to acquire 10% of China’s refinery, and also agreeing to join the Shanghai Cooperation Council as a dialogue partner. 

All these events point towards a divided East and West. Despite the inflation and recessionary fears in the West, the countries in the East have been concerned with maximizing their profits. 

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How will this affect you and me?

If OPEC sticks to its decision, it can complicate matters on several fronts. India imports about 85% of its oil requirement. Despite meeting nearly one-third of this requirement from cheaper Russian oil imports, its average oil import costs are likely to increase. This will worsen the benign inflation problem and further weaken the current account deficit levels. Only time will tell whether these cuts will eventually prop up oil prices as estimated, but for now, we can expect oil prices to continue to rise in the short term.

You should not expect your fuel expenses and monthly household bills to come down anytime soon. 

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