Get out the bunting and the party balloons, OPEC's done a deal! Or is it a bit premature.....?

Thursday 29th September 2016

  

Get out the bunting and the party balloons, OPEC's done a deal! Or is it a bit premature.....?

ref:- " OPEC Agrees to First Oil Output Cut in Eight Years " and others on Bloomberg Markets

Well, they didn't see that one coming ..... 21 of 23 oil market analysts questioned by Bloomberg before OPEC's informal get-together in Algiers had dismissed the idea that members might reach an agreement to cut production this time around. You have to applaud the remaining two as a plan to lower OPEC's output to between 32.5 and 33 million barrels per day was announced, sending prices higher by about 6% and no doubt putting a smile back on the faces of oil industry executives.

The sharp market reaction and the sight of traders scrambling for cover revealed how just sceptical they had been that OPEC would be ready to show the cooperative spirit required to forge an agreement. It's hard to be too critical ..... scepticism has become something of a default position when it comes OPEC-watching in recent times, for us as much as the next man. We did say a couple of weeks ago that we felt a deal was closer, but can't pretend that we thought it likely to come at the Algiers meeting.

So what does it mean? When the cut comes into effect, it means that the lower end of the target range will equate roughly to a 750,000 bpd drop from OPEC's August production level, according to their own numbers.  Assuming all goes according to plan, in time and IN THEORY that could translate into a $7 - $10 rise in the cost of a barrel of oil according to Goldman Sachs. It should be said in the interests of balance that it's not a view shared by everyone, particularly if they consider that the assumption is too big a one to rely on. If true though, it obviously means better prospects for oil-producing countries large and small and for oil companies --  it might even bring some more US shale firms back into the game.

Most interestingly, it also means that Saudi Arabia has changed its position regarding Iran. Whilst the Saudis and most other big OPEC producers will obviously be subject to cuts, the Iranians will be exempt. This represents a major concession from Riyadh , but may also be read as a measure of the financial difficulties faced by the Saudis after such an extended period of low prices. Former Oil Minister al-Naimi may have said that it didn't matter if the Saudi-led pump-at-will policy led to $20, $40, $50 or $60 oil, but it turns out that it DOES matter ..... a lot.

Saudi is poised to rack up a record budget deficit this year and has been spending heavily out of foreign-exchange reserves. The government has been forced to cut bonus payments to civil servants and there is even anecdotal evidence of delays in payment of government contracts. Don't misunderstand ..... it's not as though Saudi's issues should be confused with the desperate problems facing the likes of Venezuela say, but the extra revenue generated by higher oil prices for the sake of a small production cut will be very welcome. Just in case anyone was in any doubt, that's what's driving Riyadh's more accommodating stance towards Iran, and definitely not any new-found warmth between the great regional rivals.

The deal signifies a return to "supply management" after two dramatic years of a free-for-all in oil markets that has seen a crash in prices. Many will be hoping that supply management = price management, but of course it requires levels of demand to keep up with expectations for that to be true. Nevertheless, in theory the deal does represent a fundamental change in OPEC's strategy and you'd imagine that most producers will be thinking "not before time".

So what are the potential problems?

As ever, there are plenty ..... the details of the agreement  -- who cuts and by how much, even who's allowed to pump a little more  --  will not be finalised until OPEC's November meeting. The possibility of members being unable to agree on these details is a live one. And how confident can we be that all parties will stick to their quotas? After all, OPEC's history is not entirely reassuring on that front. Most fundamentally, OPEC accounts for just 40% of global production  --  will they be able to persuade non-OPEC producers to show similar restraint? It's not much good cutting your own output if the rest of the world just ups theirs.

Non-OPEC Russia is the biggest player in this. At present, they are pumping oil like there's no tomorrow : initial estimates for Russia's September production are put at 11.1 million barrels a day, easily a post-Soviet era record and up 400,000 bpd from August. On the face of it, Russia does not give the impression of a country planning to rein back output. Or does it? Russia has been a significant broker between often discordant voices within OPEC as the deal was being agreed, so perhaps we can assume that they will play their part come November. It's very possible that they've ramped up production just so they can show themselves willing and responsible by announcing their own cuts to go alongside those of OPEC.

Who knows? There's no doubt that the oil market is a more bullish place than it was 24hrs ago, but there's still a lot that can go wrong and don't forget that the oil market is still a long way oversupplied. As we write, prices are giving a little bit back this morning indicating a touch of cold-eyed realism may be following last night's euphoria. Still ..... it's a start, right?