It’s Not Always About You

The recent decision by OPEC+ to cut production quotas by 2 million barrels per day was definitely attention grabbing, and not in a good way. Coming just a month before the U.S. midterm elections and during the ongoing Russian invasion of Ukraine, commentators have rushed to weigh in on the political implications of the move, including the impression that it helps Vladmir Putin and Iran and hurts Joe Biden. After all, President Biden had visited Saudi Arabia recently and encouraged them to increase oil production and moderate prices, apparently to no effect. (Maybe he should have grasped the orb.)

The uproar is a mixture of puzzling and obvious: puzzling because OPEC and OPEC+ have been setting quotas off and on for most of four decades, and why this particular move should suddenly be treated as a major political attack on the U.S. and/or Biden Administration thus seems odd. However, given the upcoming elections and voters’ concerns about inflation, the move has struck a nerve, particularly with Democrats. Republicans are gleeful at the demonstration of Biden impotence. But readers would be cautioned against overinterpreting the development in the context of either U.S. midterm elections and/or the war in Ukraine.

There is a definite correlation between the move by OPEC+ and the afore-mentioned political impacts, but is there causality? As usual, pundits of all stripes have claimed to understand the real intent behind the moves, especially relating to U.S.-Saudi relations. Of course, claiming that the Saudis are angry with the Biden Administration because it might allow Iran to make more money exporting oil contradicts the argument that the quota reduction was intended to help Russia and Iran. But pundits often observe consistency in the breach.

Since 1973, the U.S. has consistently urged the Saudis and other oil producers to moderate prices, the one exception being then-Vice President George H. W. Bush’s 1986 visit to Riyadh in which he complained of the damage to the U.S. oil sector from the recent price collapse. That price collapse—which some argue was done at Reagan’s urging to hurt the Soviet Union—occurred after the Saudis, facing a near-cessation in oil sales, abandoned their policy of being the swing producer. That involved absorbing short-term fluctuations in demand for OPEC oil to stabilize prices.

As the figure below shows, acting as swing producer was actually quite successful in terms of keeping world oil prices stable, but a failure in that Saudi exports mostly swung down, not up. By late 1985, nearly all of their production was going to cover domestic demand and some barter deals. In theory, the Saudis could have maintained the price of oil—by buying up the market surplus. Obviously, such was not going to happen.

Back to the present. Before the quota reduction was announced, oil prices had been slipping, dropping about $10/barrel with WTI going below $80 for the first time since January. Warnings of recession were growing and both OPEC and the IEA reduced their demand forecasts for 2023 by 0.4 mb/d and 0. 5 mb/d respectively. Which would make the 2 mb/d quota reduction seem overdone, except that first, most of the demand weakness is in the next six months, and second, forecasters traditionally are slow to factor recessions into their forecasts, usually waiting until the trend is well established and sometimes in the rear-view mirror. This makes sense since a recession is a departure from the norm and official organizations are necessarily reluctant to get ahead of uncertain and changing developments. But third, the 2 mb/d is a nominal figure, since most OPEC+ members are not meeting their quotas now, so that the actual production change should be about 1 mb/d roughly similar to the expected loss of demand in coming months.

Still that implies some tightening the of market is possible, given the prevailing market forecasts. Indeed, global oil inventories, while recovering, remain well below normal. Lower demand means the desired inventory level should also be lower, but demand will only drop by a few percent.

A better indicator can be found in the financial markets, where the pricing of oil is done for current and future supplies and the difference indicates the value of prompt or physical supplies. If the current price is higher than the future price, known as backwardation, then trades perceive market tightness. The greater the level of backwardation, the tighter the market.

The figure below indicates the difference between the first month futures contract and the fourth month contract for this year. The backwardation jumped when Putin invaded Ukraine, as buyers scrambled for physical supplies. More recently, the level dropped with growing signs of economic weakness. The quota reduction did cause a bump up, but that is already fading implying that traders/buyers are not concerned that supplies will become tight. Basically, they are confirming the quota cut was necessary.

The outrage amongst American politicians is already starting to fade, partly because of their short attention spans (same for the media and the public), but also because the oil price is already lower than it was before OPEC+’s startling announcement. The market might tighten further in coming days, but for now, it appears that the group actually read the tea leaves better than the rest of us. Which implies that the move was not meant to send a political message after all, despite all those convinced it was all about them.