What Bill Gross said about the economy explains why the OPEC output agreement won’t work

‘From OPEC’s perspective the lower output deal should shift the pricing pendulum away from oil consumers and back towards oil producers’

PUBLISHED : Tuesday, 06 December, 2016, 10:22am
UPDATED : Tuesday, 06 December, 2016, 10:31pm

The Organisation of the Petroleum Exporting Countries (OPEC) has agreed a cut in its combined daily output for the first time in eight years but question marks remain over the implementation of the November 30 deal, let alone the chances for a higher oil price that can then be sustained.

On the supply side, internal differences within the oil cartel may re-emerge to confound the agreement. Also, while some non-OPEC countries may co-operate by cutting production, others may ramp it up to take advantage of a higher crude price.

Meanwhile, on the demand side of the equation there is the issue of whether the world economy, where productivity has hardly been soaring even with a lower crude price and where what growth there has been has largely been financed by taking on higher and higher levels of debt, can actually afford more expensive oil.

OPEC can partly control supply but not demand

As regards the deal itself, OPEC “decided to reduce its production by around 1.2 mb/d [million barrels per day] to bring its ceiling to 32.5 mb/d, effective 1st of January 2017.”

However it should also be pointed out that this figure excluded Indonesia who was suspended from the cartel due to Jakarta’s inability to agree the size of its own quota cut. Indonesia ordinarily produces some 750,000 b/d and will surely continue to do so.

Then there is the possibility that Saudi Arabia, who is set to cut production by 486,000 b/d, may well find the exclusion of Iran, its regional rival, from the output cut, a bitter pill to swallow, given their geopolitical differences.

Specifically, having lost some market share in China to Iraq, Iran and Russia over the last few years, Riyadh might yet be uncomfortable with the idea that output cuts, largely borne by Saudi Arabia, end up lifting the oil price to the benefit of Baghdad, Tehran and Moscow.

There’s also the fact that even if non-OPEC countries such as Russia might agree to implement an output cut, others such as Canada and US shale producers will surely look to capitalise on OPEC’s decision to boost their own production and lock in the higher margins offered by any move up in the oil price.

OPEC has influence on the oil price but it is not the dominant force it was back in the 1970s, while US President-elect Donald Trump has already promised a bonfire of regulations that he sees as impediments to the expansion of domestic US energy production.

As Trump told the Shale Institute Conference in September, “you will like me so much”.

Indeed, as regards shale, the US Geological Survey announced on November 15 that it had assessed, in Texas’ Wolfcamp Shale, what it regards as the largest deposit of untapped oil so far discovered in the United States, with the field containing an estimated 20 billion barrels of oil worth US$1 trillion US dollars based on US$50 a barrel.

And that’s just the supply side of the oil equation.

Last Thursday, an email to investors from Bill Gross, manager of the Janus Global Unconstrained Bond Fund, may have been casting doubt on the durability of the US equity market rally that has followed Donald Trump’s election but the substance of his comments could equally be applied to the outlook for the oil price.

“A strong dollar and continuing structural headwinds including ageing demographics, de-globalisation trade policies, and accelerating debt-to-GDP in almost all countries at now higher interest rates, promise to contain productivity at perhaps 1 per cent annual growth rates and therefore real GDP growth at 2 per cent,” Gross wrote.

Global productivity has hardly been tearing ahead even with a lower oil price so why would anyone automatically assume that the world economy can afford a higher price for a barrel of crude?

But OPEC’s output cut is surely a recognition that the price per barrel prevailing at the higher collective daily output figure was, for the oil producers, uneconomic.

From OPEC’s perspective the lower output deal should shift the pricing pendulum away from oil consumers and back towards oil producers.

But if the pace of economic growth among the consuming economies is insufficient to generate the income to pay the higher price, then unless those same energy consumers take on yet more debt to bridge the gap, demand may fall back.

OPEC can partly control supply but not demand. Just because OPEC members have made an agreement to cut oil output that does not mean the cartel can necessarily achieve its aim of a rise in the price of crude that will hold.