For OPEC, the Time Was Right to Move the Markets, Experts Say

OPEC’s rationale for its decision to cut crude oil production was simple, energy experts told Hart Energy: the price was too low and the time was right.

“It’s pretty clear they wanted a higher oil price over a year ago,” Ed Hirs, energy fellow at the University of Houston, told Hart Energy. What precluded that was the release of about 1 MMbbl/d from the Strategic Petroleum Reserve (SPR), which essentially added 1% to the world’s oil supply, he said.

The price of WTI rose 6.3% on April 3 to $80.42/bbl, its highest close since late January. At midday April 4, the price had slipped to $80.05/bbl.

OPEC knows “how many chips they hold, they know what their cards are. They also know what yours are and how many chips you have.” –Ed Hirs, University of Houston. 

“What OPEC did was completely unexpected,” Joseph Sykora, equity analyst at Aptus Capital Advisors, told Hart Energy, adding that many of the moves the cartel has made in the last two years have been telegraphed.

“Long positions were at a relative low point,” Sykora said. “So, you have positioning not really in a place to prepare for this news, and then the move news itself was not expected. So, to see prices jump like this—at least in the near term—makes perfect sense.”

Reduced long positions in the market was just one factor that spurred OPEC’s decision to cut production. The U.S. oil release from the SPR had ended and China had stopped buying oil to replenish its strategic reserve, Hirs said. Both actions had pretty much kept a lid on world crude prices.

“OPEC sees that,” he said.

ESAI Energy forecasts a global oil deficit beginning in May, then deepening in June, July and August. It expects the international benchmark Brent price to rise into the low-$80s in July and August, decline into the mid-$70s in the fall, then close out the year in the mid-$80s.

A winning hand

Sustaining the higher prices will rely on how committed the members are to maintaining production cuts. The cuts were made voluntarily by OPEC’s largest members—Saudi Arabia, Iraq, United Arab Emirates, Kuwait, Kazakhstan, Algeria, Oman and Gabon. The reduction constitutes about 5% of the cartel’s average production in January and February, and will begin in May.

“It does give you pause to think they are confirming what the market was fearing, which is that we are actually experiencing more of a concern for demand in the next six to 12 months,” Sykora said. “So, they took a step to try to counteract that.”

The WTI price had jumped by 13.6% from its March 17 close to the end of the month. That could have been a result of OPEC conference calls or even member countries’ own traders buying ahead of the announcement, Hirs said. He believes OPEC does not want the higher price to be temporary; rather, the cartel wants a sustained price at above $70/bbl.

But he can’t know for sure. What Hirs does know is that in the metaphorical poker game of the global oil market, OPEC members are in control.

“They know how many chips they hold, they know what their cards are,” he said. “They also know what yours are and how many chips you have.”

That’s because the state-owned sovereign wealth funds are able to buy into any publicly traded oil company across the globe and gain access to that company’s audited financials. They can also buy into any private equity firm in the U.S. and know what those portfolio companies’ economics look like. In a high-stakes global market poker game, that’s a huge advantage.

“And this is something that I think many in the oil patch have ignored at their own peril,” Hirs said. “You’re always happy to get a sovereign wealth fund in as your private equity investor, but not really understanding the fact that you’ve just let this person into your hand.”

U.S. shale producers got a taste of that when OPEC launched a price war at the end of 2014. Member states don’t mind losing millions in their sovereign wealth funds so long as they could make billions driving companies out of business.

“They have the ability to short ahead of any production increase; they have the ability to go long ahead of any production decrease,” he said. “Most MBAs who run private equity funds in the United States are absolutely blind to that.”

How the cuts hold up over time depends on a number of factors, he said, including spare capacity, investment levels and demand, Sykora said.

Also, the cuts are voluntary, which removes the burden on the group to negotiate a future increase in production with members that are underproducing their targets, ESAI said. A voluntary cut can be reversed without returning to the full group for approval.

“You don’t get overly excited about cuts like this,” Sykora said. “They can unwind this as easily as they put it on, so it’s not a structural shift.”