Commodities

OPEC considers output cuts; will they be worth it? – Commodity News

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At the end of 2019 analysts were positive that crude markets may be at the start of a bull run but China’s deadly coronavirus put a damper on those hopes in January. Amid fears of a collapse in demand, OPEC and its partners recommended further production cuts on top of an ongoing pact, but Russia decided to take more time to investigate the case, making markets wondering whether such an action would make much of a difference to the price outlook.

Coronavirus is the main risk to demand in the near-term

Even though China and the rest of the world have taken strict measures to contain the coronavirus, uncertainty remains about when the disease will reach a peak as there is no effective vaccine yet to prevent it from spreading.

In energy markets, such an incident is translated to lower demand and consequently to lower prices as travel restrictions are imposed, affecting road and air travel, and businesses are forced to stay shut after the Lunar New Year holiday, disrupting supply chains globally. The fact that China is the biggest oil consumer makes the issue exponentially worse, especially for OPEC and its allies (referred to as OPEC+) who back in December agreed to increase production cuts by 500,000 to a total of 1.7 million bpd through the first quarter of 2020 in order to balance the fall in crude prices triggered by the US-China trade war and the rising supply in the US.

Despite the supportive action, however, crude prices followed the wrong direction in January thanks to the coronavirus outbreak, with the US benchmark WTI oil losing more than 17% so far in the year to trade within the $50/barrel region at which many smaller producers are struggling to stay profitable. Last Thursday, the technical committee of OPEC+ gathered once again to propose additional cuts of 600,000 through the end of the second quarter, but Russia decided to delay its approval to assess the matter although it showed partial compliance to the cuts agreed in December.

Additional production cuts may not be in favor of Russia

Russia’s move to postpone its decision raised doubts about whether further output reductions will be effective in driving oil prices closer to $80 as Saudi Arabia, the biggest OPEC producer, desires. The problem is that if scientists fail to stop the coronavirus soon, causing a growth slowdown in China in the first and likely in the second quarter, as the outbreak may not recede until the summer if what happened with the SARS virus is to be taken as an indication, demand for crude could be hit at a time when OPEC+ is struggling to balance the market. In this scenario, Russia, which is the biggest oil exporter to China, would face lower profitability through fewer sales delivered at a lower price. It is also worth noting that China has pledged to buy US crude as part of the phase one trade deal, therefore any decline in its oil purchases would likely concern Russia and Saudi Arabia more and less so the US if the Chinese prioritized the trade deal.

The increasing supply in the US supported by technological advances is another issue. The Energy Information Administration forecasts that US output will keep hitting fresh record highs in the next two years but at a slower pace due to a slash in drilling spending. On the other hand, demand is projected to slow down, with OPEC revising down its global demand growth forecasts for 2020 to 0.99 million bpd in its February monthly report because of virus uncertainty. If estimates materialize, OPEC could see its efforts come to naught.

It could accept the proposal in the end

While the oil-dependent Russian economy is not an OPEC member, it is the world’s second largest crude exporter after Saudi Arabia and therefore its contribution to output cuts is a necessity, especially for the Saudis who aim to drive prices higher. The current cut proposal, however, may not be in favor of Russia’s state-owned oil producer Rosneft, which saw its net income narrowing from output reductions and lower prices in 2019, as it would give the opportunity to its US counterparts to steal some of its market share.

Will a production cut move markets?

But the markets have heard the story before and therefore it would not be very surprising if Russia eventually caves in the next few days. Besides, since demand and not supply disruption seems to be the main risk in the oil market, the answer to OPEC’s proposal should be positive. As usual, though, Russia will try to negotiate its share in order to reduce the size of contribution even though history has shown that it tends to cut a smaller amount than the agreement states.

In terms of market reaction, analysts are already pricing in an output cut since Russia’s key oil producers seem to support the idea even though no official announcement about the size of the cut has been made so far and ahead of the OPEC’s conference on March 5-6.

Hence, if Russia welcomes Saudi Arabia’s proposal, crude oil futures may not gain much unless the output cuts come in larger than analysts expect, in which case WTI crude could initially aim for the 52.00 resistance area and then for the 20-day simple moving average (SMA) and the 23.6% Fibonacci of 53.25 of the 65.67-49.31 downleg. Otherwise if the amount of decline appears smaller, WTI crude could drift lower to test the 49.31 base, where any violation could see additional losses towards the 48.00 and 47.00 psychological marks.

As regards the international benchmark Brent crude, it could search for immediate resistance within the 55.80-56.80 area, while slightly higher another barrier could emerge in the 57.70-58.35 zone which includes the 20-day SMA. In the negative scenario, Brent could revisit its recent lows in the 54.00-53.11 territory, with the 52.20 barrier being also in focus in case of a sharper decline.