Deal Or No Deal?

30/09/2016 at 4:31 pm

It was obvious at the start of this year that the behaviour of the oil price would be one of the key economic variables of 2016. We saw sharp falls early on, with lows below $30 repeatedly tested. (Had these persisted the disinflationary impact of cheaper energy would have continued into the winter.) Then there was a convincing recovery, along with risk assets, into the spring. And over the past few months the price has stabilised convincingly for the first time since the initial fall in 2014, holding a range of about $45-50 since the middle of April.

This week’s OPEC meeting might be expected to reinforce that stability. The decision was announced on Wednesday to reduce the cartel’s crude output by about 0.25m-0.75m barrels per day. (Details of individual production quotas are to be agreed at the next meeting in two months’ time.) There are the usual question marks over the credibility of the OPEC system – diplomatic tensions between its members, doubts as to their adherence to quotas in the first place and so on. Crude has fallen back a bit today on profit taking and on fears that the deal, modest as it is, might yet fall through.

But the announcement was significant. It is the first cut agreed since 2008. Should November’s meeting prove fruitful the group’s quotas will have changed for the first time in five years. It has encouraged Russia to start talking about a production freeze again. It hints, in short, at the firming of the bottom end of the range we have seen oil prices occupy over the last five months.

This is doubly true when we look at recent changes in the balance between crude supply and demand. Over the course of 2014, the six-monthly average global production level increased by 2.8m bpd as against a 1.1m bpd increase in demand. Albeit on a much lesser scale the reverse has happened since: six-monthly average global demand has risen by 2.3m bpd versus a 2.0m bpd increase in supply. In fact the production surplus as of August, again using the six-monthly average, had fallen to 443k bpd down from a high of over 1.5m bpd in mid-2015. So the OPEC cut, especially if accompanied by a Russian cap on output, would bring supply consistently below the level of aggregate demand for the first time in over two years.

Looking at this from the other end, rising prices would come under pressure from increased production from other sources, notably US shale. Cost efficiencies have already seen the oil rig count rise by 32% from the low it reached back in May – and it remains way off the mid-2014 highs. The current range for crude, then, would appear to be secure both from persistent falls and persistent increases. It could be a case of 2012-2013 all over again, just at the $50ish per barrel mark rather than $110.

There we must add a note of caution. For some producers, $50 per barrel is too low. OPEC granddaddy Saudi Arabia has just had to funnel billions of dollars worth of state support into its banking system. Its reserve assets peaked at $731bn back in 2014 (about 100% of GDP – quite a cushion). Since then they have fallen by almost a quarter to $553bn. That’s a sharper fall than Russia has seen over the same period (-15%. Indeed, Russian reserves have been climbing steadily for more than a year). At the extreme end of the spectrum, there is the bitter human tragedy unfolding amid the ruin of Venezuela. The fall in crude has not killed off shale, but it has put several economies under varying degrees of strain. If there is a real challenge to the OPEC deal this blog suspects that it will come about from economic imperatives rather than political disagreement.

Deal or no deal, oil seems to have found its level more securely than ever now. Regular readers will know what this means for inflation, and, depending on the reaction function of the central banks concerned, monetary policy in due course.

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