OPEC+ Throws a Curveball

The Organization of the Petroleum Exporting Countries and allied producers (OPEC+) have surprised the market with a large production cut. Saudi Arabia and other producers will make voluntary cuts of 1.16 million barrels per day (b/d), joining Russia’s current cut of 500,000 b/d. The cuts will begin in May and will last through the end of this year, barring future adjustments. Actual cuts will probably be well below this 1.66 million b/d headline figure, but prices rose by more than 8 percent when markets opened Monday in Asia. Saudi Arabia is likely worried about last month’s sharp price downturn, as well as signs of a relatively soft recovery in China. OPEC+ wants to defend $80 per barrel, and the group must have concerns about the macroeconomic picture. This cut suggests the group will not be idle.

Few analysts expected yesterday’s change in tack. After all, Saudi energy minister Abdelaziz bin Salman suggested just a few weeks ago that the “only course of action” was to maintain the group’s 2 million barrels per day production cut in October 2022. But OPEC+ jolted the oil market with a proactive move to boost the price through additional voluntary cuts. Russia had already pledged to reduce output by 500,000 b/d beginning in March, although these cuts were hard to discern last month, and calling them “voluntary” would be generous.

This announcement would have been less surprising several weeks ago. Last month, oil prices tumbled after the collapse of Silicon Valley Bank (SVB) and Signature Bank and the forced takeover of Credit Suisse by UBS. As traders worried that banking sector problems could spread to the real economy, Brent crude fell by more than 12 percent between March 9 and March 17, to a low of around $72 per barrel. The oil market has been preoccupied with U.S. Federal Reserve policy, as the Fed continues to gradually raise interest rates. Systemic risk in the banking sector akin to the Global Financial Crisis now seems less likely, but the SVB episode dented confidence. One concern is that higher interest rates, plus more conservative bank lending, will harm economic activity. Traders had pared back their holdings and the net length of West Texas Intermediate (WTI) and Brent futures and options contracts to the lowest level since 2011. Brent backwardation (a situation when prompt crude prices exceed prices for future delivery) has risen in the past few weeks, but remains far below March 2022 levels, when Russia’s war on Ukraine created a price spike. With fewer distress signals of immediate market tightness, even perennial market bulls had downgraded their price forecasts.

Contagion concerns had subsided and prices started to rise in the past two weeks, especially after a temporary loss of some 400,000 b/d from Iraq’s Kurdistan region. As of March 31, Brent crude was hovering just below $80 per barrel. Still, Riyadh may have been spooked by the impact on market sentiment and now aims to retake control of the narrative.

Before Sunday’s announcement, the market was balancing immediate macroeconomic concerns against the expectation of promising fundamentals in the second half of the year. But the OPEC+ cut suggests the group is worried about the demand picture. It is hard to envision a strong second-half increase in global demand without a big uptick in China. If the country delivers anywhere near the 960,000 b/d in demand growth that the International Energy Agency anticipates, it may well create a tighter crude oil market. Increased domestic consumption could also limit fuel product exports, potentially leading to tighter middle distillate balances. But China’s economic outlook has fundamentally changed from the hyper-growth that fueled a commodity super-cycle in the 2000s. Even if the government meets or exceeds its 5 percent GDP growth target this year, the sources of growth are evolving and becoming less commodity-dependent.

OPEC+ is defending a higher price floor and brushing off criticism that higher oil prices will fuel inflationary concerns. The White House has criticized the cuts but does not have great options at its disposal. With the Strategic Petroleum Reserve (SPR) at just 372 million barrels after last year’s emergency sales and exchanges, and with another Congressionally mandated sale on the books for this year, more emergency releases would be unwise. Congress has now canceled 140 million barrels in scheduled sales, greatly alleviating the potential SPR rebuild challenge. But the Biden administration also missed an opportunity to restock the SPR when WTI crude prices were in its desired range of $67 to $72 per barrel, citing technical complications with refilling the SPR while releases were underway.

The U.S. shale industry also seems stuck on a lower growth trajectory, and the limited threat of a shale supply response may have emboldened OPEC+. The U.S. Energy Information Administration estimates only 500,000 b/d in crude oil production growth by December 2023 over the previous year, and there are growing concerns about “peak shale supply.”

It is unusual for OPEC+ to make such a move with prices already near $80/b, but this cut shows the group is looking after its own economic interests, without much deference to Western policymakers. If there is a silver lining for the White House and U.S. consumers, it is that these cuts will rebuild some spare capacity in OPEC+, which has dwindled in recent years. The voluntary cuts could also be unwound if market conditions change. It is possible that slower economic growth and a soft recovery in China will prevent upward pressure on prices later this year. But this cut suggests OPEC+ will take bolder steps to create a materially tighter market.

Ben Cahill is a senior fellow with the Energy Security and Climate Change Program at the Center for Strategic and International Studies in Washington, D.C.