OPEC at the Crossroads
As the OPEC oil ministers prepare to meet for their bi-annual Ordinary Meeting on 22 June, they are faced with some difficult choices. On the one hand, by extending the output cutbacks amidst a higher risk of output disruptions, OPEC risks overtightening the oil market and pushing oil prices higher, leading to an inevitable demand response. Moreover, involuntary cuts originating mainly from Venezuela, Angola, and Mexico mean that the oil market is tightening more quickly than anticipated. On the other hand, by exiting the agreement too early OPEC runs the risk of prices falling if such a decision is not supported by favourable market conditions, especially as ‘the clouds over the global economy are getting darker by the day’, and risks dismantling a historic coalition of OPEC/NOPEC producers which took massive diplomatic efforts to put together and the coordination of which proved critical for the rebalancing effort. In this Energy Insight, we consider the hard realities of oil market and price dynamics for 2018 and 2019 to derive, analyse, and assess, oil output policy scenarios that are likely to drive discussions during the upcoming OPEC Ministerial Meeting, through the lens of a structural VAR model of the global oil market.
The decision for OPEC members that have the capacity to increase production is not only whether or not to increase output, but also by how much to increase production and whether to do it incrementally. Our results call for a cautious approach in which OPEC increases output gradually and reassess its options in November as this will help keep a solid floor on the oil price, which remains a key objective for all producers. We also find that future oil demand growth (especially in 2019) hinges heavily on the outcome of the upcoming OPEC+ meeting, just as the success of its oil output policy hinges heavily on the prospects of global oil demand remaining healthy. Finally, how OPEC decides to implement the output increase also matters. If the decision is to increase output, then it is in the best interest of OPEC+ to reach a collective decision, however this may not be feasible in the current context as the producers who don’t have the capacity to increase production and those who are subject to US sanctions are likely to refuse a recommendation to increase output. If it is not possible to reach a collective agreement on increasing output, the producers who have the capacity, and who could really influence market outcomes are then faced with three options: either to extend the current agreement of output cuts in order to maintain the cohesiveness of the coalition and risk the impact of higher oil prices on demand; exit the deal altogether and announce that they will increase their output regardless of the actions of other producers, bringing to an end the framework of cooperation; not dismantle the OPEC+ deal in the next meeting and postpone the difficult negotiations until November, while still going ahead and increasing output individually.
While the last two options are not very different in terms of their impact on market balances, the choice of exit will affect sentiment and prices at least in the short-term. This shows the balancing role that OPEC has to play and the importance the key players should attach to retaining their flexibility.