The OPEC cartel led by Saudi Arabia has surprised markets by agreeing to cut production in order to boost export revenues. This effectively reflects a departure from the previous Saudi strategy of preserving market share and driving out high-cost US shale production from the market. The participation of non-OPEC members like Russia in the deal makes it more significant.
Assuming that the fractious OPEC and non-OPEC members follow through on their new production commitments, analysts forecast oil prices in the range of $55 - $60 per barrel in 2017. This will directly push up global inflationary pressures.
From a portfolio standpoint, it makes sense to reduce exposure to bonds and increase allocation to equities. Over the short term, US shale producers stand to benefit from the higher oil prices. Over the long term, higher oil prices will eventually lower the entry barriers for producers of Electric Vehicles.
Ever since it was founded in 1960, the Organization of Petroleum Exporting Countries (OPEC) has held a major sway over global oil production and consequently global oil prices. The fourteen-member cartel produces around 33 mn barrels per day, which accounts for about 40% of the global crude production. Added to this, OPEC’s ability to negotiate deals with non-OPEC producers has given it even more influence.
In the past, mutually agreed upon production quotas kept up discipline and predictability in export revenues. However, the presence of regional rivals Saudi Arabia and Iran on the same table meant that reaching consensus wasn’t (and still isn’t) easy. Since the coordinated production cuts at the height of the 2008 financial crisis succeeded in pre-empting an oil price crash, it had all been downhill. The fractious relationship between the member countries finally led to the abandoning of production quotas in 2011.
The 2014 deadlock, when Saudi refused to agree to production cuts and decided to protect its market share instead, was termed by some analysts as the demise of OPEC. It was no surprise that markets were skeptical when OPEC announced in September 2016 tentative plans to lower production.
OPEC agrees to cut production for the first time since 2008
But with its November 2016 pledge to cut production, OPEC appears to have regained its raison d’être. For now, at least. In conjunction with non-OPEC members, the cartel has agreed to collectively cut production by 1.2 mn barrels per day to about 32.5 mn b/d over the first half of 2017. Saudi Arabia has committed to cut its production by 486 th b/d while Russia has committed to cut by 300 th b/d. Meanwhile, Iran has been exempt from production cuts but asked to freeze production at current levels of about 3.8 mn b/d.
The agreement is initially for the six-month period starting January 2017, but can be extended by another six months. Economists are now forecasting oil prices in the range of $55 - $60 per barrel in 2017. This is assuming that countries follow through on their commitments. Skeptics have pointed out that OPEC members have a history of defecting from their production agreements. In that case oil prices will tend to drop once again.
Fixed return instruments will suffer due to rise in inflation
The implication of the OPEC production cuts from an asset class angle will be through the return of inflationary pressures. The rise in inflation from higher oil prices would reduce returns on fixed-rate instruments like bonds and increase the attractiveness of equities.
If the cuts are successfully implemented and extended for the full year of 2017, the rise in oil prices will make high-cost US shale production profitable once again. The shares of the top shale companies like Marathon Oil (NASDAQ: MRO), Newfield Exploration (NASDAQ: NFX) and EOG Resources (NASDAQ: EOG) have bounced since the OPEC announcement.
Yet another investment implication, albeit for the long term, is for alternative energy sources. Higher oil prices will eventually lower the entry barriers for producers of Electric Vehicles (EVs). The cost of production of EVs has already been on the decline due to recent technological advancements like recycling of rare earths in Lithium-ion batteries. Seen from this lens, the OPEC deal may well be a blessing in disguise for EV manufacturers.
Janki Sharma is a freelance economist based in Singapore and writes for Macrovue.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.