Brad Rotolo
Reality Check

What Does OPEC’s Production Cut Mean for Oil?

By, 12/01/2016
Ratings724.118055


There’s more where that came from. Photo by yodiyim/Getty Images.

At long last, the Organization of the Petroleum Exporting Countries (OPEC) reached an agreement to cut production on Wednesday. While details are scarce, comments from oil ministers indicate the group will cut oil production to 32.5 million barrels per day (Mbpd), from recent levels of 33.5 Mbpd. Despite the hype, however, the change is basically window-dressing. It probably won’t much alter global supply or improve the outlook for Energy firms. Their earnings are tied to oil prices, which likely remain lackluster for the foreseeable future (albeit with short-term volatility).

This is OPEC’s first official action of this sort since oil began crashing in 2014. OPEC surprised markets that November by declining to cut production, as had been widely expected at the time. Oil supplies were growing briskly, primarily due to new output from US shale production, which got a boost from developments like horizontal drilling and hydraulic fracturing. The resulting oversupply led to the last two years of oil weakness. With Wednesday’s agreement to cut production, OPEC is arguably moving back to its traditional role of attempting to target a price range for oil.

But there are good reasons to be skeptical. First, and most importantly, OPEC does not control the price of oil in the long or even intermediate term. True, the cartel members account for a little more than a third of daily production, so their actions and words matter in the short run. But OPEC cannot counteract market forces, which tend to bring supply back relatively quickly when prices rise. US shale producers have typically responded within 3-6 months to big moves in oil prices, and many operators are profitable with crude prices significantly below today's level, suggesting they won't hesitate to keep pumping. Additionally, costs continue to fall, lowering break-even prices in several US shale fields and further incentivizing production. The market is too nimble and too global for OPEC to manipulate for long.

Furthermore, other aspects of this deal suggest it may have little real-world impact. For one, if enforced, it would return OPEC production levels to where they were in Q1 2016—still very high. Plus, as with all OPEC agreements, the enforcement mechanism to keep members honest is largely toothless. And if pre-deal chatter is to be believed, there is likely a shelf-life for a production curb, so member-states could go back to producing at will after a year or so. Still, it is worth reiterating that few details are known at this point, and oil markets could remain volatile as more specifics emerge.

At a high level, Energy stocks’ outlook depends on supply and demand drivers. Oil supply has fundamentally changed with new production technologies, and this deal doesn't alter that backdrop. With crude oil prices likely to remain sluggish, this isn’t the time to drill down deep for smaller, lower-quality oil producers, which will likely continue to struggle. Rather, the largest integrated—and global—firms are likely best suited to weather the continued storm.

 

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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