The analysts (including myself) and journalists who cover the global oil markets sometimes mistake market developments for a game of Risk with two or more masterminds playing for mastery of the board. This week's meeting of OPEC+ member countries, which cut the global crude oil supply by 2.0 million barrels per day (b/d), is a case in point. With the whole world watching, this decision may be over-analyzed for its geopolitical portent. Reporting has suggested it represents a snub of the Biden administration, a realignment of Saudi Arabia with Russia over the United States, a punishment of Europe and Ukraine, a statement against last Friday's price cap on Russian oil cargoes.
For sure, stakeholders make decisions that can have multiple intended and unintended consequences and invite many different interpretations. If we consider the facts in the market, however, it may be easier to understand this OPEC+ decision as more a tactical move than a strategic advance. Moreover, it does not preclude new decisions that reverse this one in the months ahead. Even though the communique indicates the agreement will extend though the end of 2023, it provides for ad hoc changes along the way.
So, what's really behind the OPEC+ cut in production? A substantial crude oil surplus in the global oil markets. This surplus is largely the result of four things:
- A healthy growth in U.S. crude oil production, which has risen by about 700,000 b/d since the invasion of Ukraine.
- A tremendous drawdown (1.0 million b/d in the summer months) of the U.S. Strategic Petroleum Reserve by the Biden administration to temper crude and thus gasoline prices.
- Even with self-sanctioning by buyers of Russian crude oil, Russian crude oil production and exports have fallen by distinctly less than expected when economic sanctions were first adopted last spring.
- China's zero-Covid policy has led to a contraction in Chinese oil demand this year.
The resulting surplus combined with surging inflation, a very strong dollar (in which oil is priced), and very real concerns over recession in key regions has led to a $15 to $20 drop in crude oil prices over the last month. Concern about excess crude oil supply is not unreasonable.
Also, the OPEC+ Agreement made at the height of the pandemic came to an end this summer. This week's decision was taken in part to extend the "Declaration of Cooperation" through 2023, allowing for the continued collaboration of these countries, including Russia. At the same time, the existing quotas of several member countries are immaterial. Many of the countries, including Russia, are already producing well below their allocations. So, one small benefit to the group of making this agreement is to bring the existing quotas closer in line with actual production. This means much of the cut in supply is on paper. Indeed, the cut in actual physical barrels will be about 1.1 million b/d not 2.0 million b/d.
In addition, the Saudi-Russia alliance at the heart of OPEC+ is not a trivial alliance for Saudi Arabia given that Saudi Arabia and Russia are the largest crude oil producers (after the U.S.) in the world. So, it is likely not an easy bridge to burn for the Saudis. In the meantime, relations between the U.S. and Saudi Arabia are strained. It is probably a mistake, however, to paint this as an aggressive repudiation of the U.S. and even closer ties to Russia. The U.S. does still provide a security umbrella to the Arab Gulf countries.
What comes next is more important than this week's decision.
The agreement has garnered too much attention because of the many geopolitical interpretations that can be fashioned. The next few months is where the focus should be as they will be an important proving ground for the Arab Gulf countries. In early December the ban on Russian oil imports to Europe and the price cap of the G7 countries will go into effect. The flow of Russian crude oil will be impacted by a rerouting of trade, uncertainty over pricing and the likely shut-in of as much as 1.0 million b/d of Russian production. In addition, economic activity my contract in recession. As these developments unfold, the decisions of the Arab Gulf producers may become more pertinent and maybe more relevant to geopolitical interpretation.