OPEC and key partners opted for a middle path coming out of the 175th meeting of the OPEC Conference, agreeing to cut oil production by 1.2 million barrels per day (bbl/d) from October levels (an even steeper cut than versus November levels). We expect the move to support prices in the low $60s/bbl for Brent crude and in the mid-$50s for WTI.
We believe the production cuts are prudent and represent a “third way” to address market concerns that seeks to avoid some of the negative outcomes of recent moves. In 2014, OPEC elected to pursue a policy of market share rather than output cuts, which led to a collapse in oil prices; in 2016, in coordination with several non-OPEC producers, the cartel reversed course and cut output, spurring a gradual doubling of prices. This year’s OPEC agreement seeks to limit the market imbalance and stem the recent price decline while not driving prices substantially higher – a move that more closely resembles behavior prior to 2014.
How we got here: evolution of the oil market in 2018
Oil prices had been on a steady upward trajectory after the U.S. exited the Iran nuclear deal (Joint Comprehensive Plan of Action, or JCPOA) in May, aided by the previous period of OPEC output restraint. In June, partly in response to the U.S. renewal of sanctions on Iran and to offset declines in other producers, such as Venezuela, OPEC reversed course and began opening the spigots. This helped push output to new record highs in October and November.
In an October blog post, we cautioned that oil had run ahead of fundamentals and that a release of waivers for Iran oil consumers could cause prices to retrace back to the mid-$70s – effectively erasing some of the geopolitical risk premium that had entered the market. Fast-forward two months, and oil had fallen precipitously, well below the 70s, and the granting of waivers was insufficient to explain the drop. A surge in U.S. supply, which has grown by nearly 3 million b/d annualized over the past three months, was the primary cause. In August and September, U.S. output was between 400,000–500,000 bbl/d above International Energy Agency (IEA) and consensus projections. The surge was particularly notable given concerns about pipeline constraints. In effect, both the U.S. and core OPEC producers each managed to replace any decline in Iranian exports, allowing inventories to build.
This output jump coincided with a deceleration in global demand growth owing both to temporary factors (such as low water levels in the Rhine River that disrupted transport, leading to internal stock draws) and macro issues, including a continued decline in global manufacturing purchasing managers’ indexes (PMIs). Falling petrochemical demand, which coincided with the drop in global automobile manufacturing, had a particularly meaningful impact on the light ends of the barrel (i.e., liquefied petroleum gases, such as propane and butane).
OPEC’s ‘third way’ sidesteps key risks
Against this backdrop, OPEC faced a particularly thorny challenge: Cutting too much and supporting prices at too high a level would risk curbing demand and supporting U.S. production expansion; and reverting to a market share war would risk another price collapse, with the attendant collateral damage to producing economies.
OPEC opted for a third way: Cutting enough to prevent notable storage builds, while at the same time supporting prices at levels that should slow U.S.-driven investment. The cut was below what the Joint OPEC-Non-OPEC Ministerial Monitoring Committee (JMMC) had suggested was necessary to rebalance the market, potentially leaving oil bulls disappointed. However, with prices below $45/bbl in many onshore U.S. producing basins, a deceleration in U.S. production growth should help achieve this ultimate goal. In addition, lower prices should give demand a shot in the arm. Given the lower prices and rebuilding inventories, we would also expect the U.S. to be aggressive in pressuring Iranian exports heading into the second quarter of 2019, when the current waivers are set to expire.
On net, we believe OPEC’s policy coming out of the December meeting should support oil prices in the low $60s for Brent crude and the mid-$50s for WTI. Downside risks could stem from greater-than-expected economic deceleration. On the upside, a reignition of the global manufacturing chain would go a long way toward supporting demand and market sentiment.
For more of PIMCO’s views on real assets and the complex drivers of inflation, see our inflation page.
Greg Sharenow is a PIMCO portfolio manager focusing on real assets and is a regular contributor to the PIMCO Blog.