Oil Deal Struck

Oil Deal Struck

Earlier this week, after months of negotiations, OPEC, along with Russia, agreed on production cuts for the first half of 2017. In previous blogs (click here to read), I have discussed the political differences of member states, in particular Iran, Saudi Arabia, and Russia; however, because of economic stress, all three were able to reach an agreement. In fact, it was actually Russia that worked to put the two bitter rivals together.

Lower oil prices have had a devastating economic impact on oil producers. Even Saudi Arabia was feeling the pinch as its budget deficit grew due to falling oil revenues. Russia is dependent on commodity exports, and the low oil prices, coupled with international sanctions, have had a staggering impact on its economy. For the past two years, Russia’s economy has shrunk while it is spending up to $150 million a month on military contractors in Syria. Iran, which has just seen its sanctions lifted, has been particularly reluctant to any production cuts now that is regaining lost market share.

But economics pushed the group to overcome their political differences and collectively reach a deal. The agreement calls for OPEC to set production at a target of 32.5 million barrels/day, down from its current production of 33.7 million barrels/day. Therefore, the group agreed to cut output by 1.2 million barrels/day. Much of the production cut will be borne by the Saudis. They agreed to reduce output by 486,000 barrels per day – current production is 9.7 million barrels/day. Russia agreed to cut production by 300,000 barrels per day – current production is 10.9 million barrels/day. Even Iran agreed to cut production by 4.5%; however, given the need for massive capital spending for Iran to ramp up production, the concession was not too great.

The announcement sparked a rise in oil prices, as you can imagine. Oil moved above $54 when they announced a deal earlier this month but then fell back below $50 as investors were skeptical that the deal would hold. Now that the agreement has been signed, oil again is above $50/barrel, which is not that much higher than its average price of $48 since June.

There are three reasons why we think the price of oil may not move back to the highs it attained in 2014 when it reached $107/barrel.

First, global growth has been weak so the announced cuts will do little more than to bring supply more in line with current demand. Second, the record of OPEC compliance with agreed-upon cuts is poor. Additionally, non-OPEC member Russia will also have to prove to be a reliable partner. Against this backdrop is the fact that the political riffs between Saudi Arabia and Iran and Russia have not abated; quite the contrary, war is still raging in Syria.

Finally, the new “swing player” may be the US. Many of the wells that have been closed recently can become profitable with oil trading in the $50 – $60 range. Because of new technologies, many of these closed wells can be brought back on line within 30 days. Consequently, US production could increase by 1.25 million barrels/day within a month.

Therefore, we may see oil trading in the $45 – $60 per barrel range for the foreseeable future, which would not be bad for the economy. At these levels, many US producers can become profitable again and the gain in prices should not be large enough to choke off growth in other areas of the economy. Globally, oil producing nations would fare better without the devastating negative effect on the consuming nations seen when prices were above $100/barrel.

 

Washington Trust Bank believes that the information used in this study was obtained from reliable sources, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation for business or a recommendation of the purchase or sale of securities or commodities.

About The Author

Rick Cloutier, CFA is the Chief Investment Strategist for Washington Trust Bank with over 20 years of portfolio management and investment experience. Rick designs and implements investment and risk management strategies for the bank’s clients. Rick has written numerous articles for Investopedia and wrote a weekly column for the Fall River Herald News in Massachusetts. His research has appeared in numerous journals, including the Journal of Investment Management and Financial Innovations, as well as, the International Journal of Revenue Management. He provided a nightly commentary on WALE radio and authored the novel Caveat Emptor. Rick earned his MBA at Boston University.