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OPEC - Compliance or Bust?

Oil & Gas	1009 VIEWS
Oil & Gas
1009 VIEWS

Thursday, October 08, 2020 / 09:38 AM / By FDC Ltd / Header Image Credit: Rigzone

The Organization of Petroleum Exporting Countries (OPEC) and its allies (together called OPEC+) met on September 17, 2020 to reassess plans to further ease output curbs in the coming months, and to assess compliance levels amid wavering global demand recovery. The outcome of the meeting was predictable - total compliance or bust. The Joint Ministerial Monitoring Committee (JMMC) urged OPEC+ members to take further measures, if need be, to prop up oil markets as the global economic recovery stutters. While not announcing additional output cuts, the JMMC emphasized the need for full compliance to agreed quotas - as well as for compensatory cuts by members who had previously exceeded agreed volumes.

Backdrop

OPEC eased output cuts from 9.7 million barrels per day (mbpd) in August to 7.7mbpd in September, amid signs of demand recovery and steadily rising oil prices. But the recent resurgence in COVID-19 cases has dampened the outlook for global oil demand. The cartel went into the meeting following a second consecutive downward review of its oil demand forecast for 2020. According to its monthly oil market report (MOMR) for September 2020, the cartel now expects the COVID-19 pandemic to lower oil demand by 9.5% or 9.5mbpd from 2019 levels. OPEC also adjusted its outlook for non-OPEC supply to a less gloomy contraction of 4.1% as shale oil output recovers. The cartel now fully acknowledges that the negative effects of COVID-19 will hit harder and linger for much longer than previously anticipated. In its report, it says "the impact of COVID-19 related developments on already fragile global economic conditions remain[s] challenging and will require coordinated global policy action from all market participants".

Added Pressure

In the build up to the meeting, oil prices fell below $40 per barrel (pb), for the first time since June 25, before recovering to $42pb. This was due to a growing oil glut amid a slow recovery of Asian demand. The bearish sentiment was further fueled when Saudi Arabia cut its October selling prices in response to a spike in global COVID-19 infections. The bearish sentiment was in spite an improvement in compliance to OPEC+ output cuts. It is also noteworthy that as we enter autumn, the effect of the US summer driving season on oil prices (which typically represents the peak in demand) will fade. In addition, just a day before OPEC met, the US Federal Reserve held interest rates near zero. It also signaled that they would stay there through 2023 until the US achieves maximum employment and 2% inflation. The US dollar rallied in response as markets interpreted the "hold" call as monetary tightening. A stronger dollar will spark a drain in the current global liquidity surfeit and has negative connotations for capital flows into emerging markets as well as for oil prices. The implications for poorer OPEC members like Nigeria and Venezuela are severe as these countries are battling with deteriorating external balances and widening fiscal deficits.

What Next?

In the coming weeks, OPEC+ will be looking to send a strong signal of a united front willing to do "whatever it takes" to drain oil markets of the current glut. That is the only thing under its control right now. With resurgence in global COVID-19 cases and the oil demand picture dimming, a strict adherence to quotas or going above and beyond to keep the cartel's total production below the agreed cut of 9.7mbpd is the only weapon OPEC has in its armoury. Nigeria and other serial defaulters like Iraq, who are grappling with major fiscal challenges, have asked the group to extend the period for compensatory cuts to the end of December 2020. Markets are paying keen attention, not just to the compensatory cuts but to production in the United Arab Emirates that was as much as 20% over the limit. The prospect of increased oil production in Libya remains another major worry. The country, which is in the middle of a civil war that has virtually shut down its oil industry, is exempt from oil cuts. Production is down to 100,000bpd from 1.1mbpd at the end of 2019 and this could be restored soon.

However, in the event of another round of global lockdown measures and oil demand stalling back to levels in the second quarter, is OPEC willing and able to respond in the same measure that it did to prop up oil prices? Given the financial losses incurred by the poorer and more vulnerable members, will a united front based on common interest still be viable? Or will members start lowering their selling prices to gain market share like the Saudi's earlier in the month? This is unlikely, but in the event that they do, it could degenerate into a free for all - the type that led many to believe that OPEC was faced with extinction in 2016 after it faced unprecedented competition from US shale oil production. With the US shale industry on the verge of bankruptcy, OPEC will do well to stay the course and ride out this storm.