On 30th November 2016, the Organization of the Petroleum Exporting Countries (OPEC) announced their first oil production agreement in eight years. The historic agreement will see oil production by OPEC nations cut by 1.2 million barrels per day (b/d) to about 32.5 million b/d for six months from the start of January 2017. The agreement also has an option to extend the agreement to the end of 2017. Aggregate production has been stated in terms of the 14 OPEC members including Indonesia, although Indonesia is no longer a member as of this meeting. Non-OPEC members including Russia have also agreed to lower production by 600 thousand barrel per day (kb/d). The heavy lifting though looks set to be done by Saudi Arabia who has agreed to reduce output by 486 kb/d. At the same time the Saudis appear to have softened their stance on Iran somewhat with the latter now freezing production at nominally less than 3.8m b/d and marginally higher than current levels. Iraq, who had previously disputed price cutting, agreed to a cut of 210 kb/d. OPEC will also establish a monitoring committee with the aim of improving compliance from the historical record.
Comparing the agreed reductions among member countries
Comparing the agreed reductions in absolute terms, Saudi Arabia is committing to the largest reduction. However, comparing the agreed output ceilings against November 2014 production (before the initiation of the market share maximization strategy), both Saudi Arabia and Iraq will hold onto the majority of their gains. Viewed in terms of percentage reductions to baseline levels, OPEC member countries are very tightly grouped around the 4.4 per cent to 4.8 per cent range(not clear), with an average reduction of 4.56 per cent. Indonesia requested for suspension of its OPEC membership because as a net importer of oil, it will struggle to support the deal. Iran wanted exemptions on account of an attempt to recapture the market share lost under years of western sanctions. Libya and Nigeria, asked for the same, since exports have been hampered due to violence. The issue of offsetting increases from exempt countries has become all the more pressing because Libya raised its production by 150 kb/d and Nigeria by 180 kb/d in October, while Saudi Arabia has been slow to reduce production from the summer ramp-up. The only factor depressing production in October was maintenance activity in Angola which lowered output by 170 kb/d to 1.52m b/d.
The significance of non-OPEC contributions
On the subject of non-OPEC contributions to a purported 600 kb/d reduction, meetings are scheduled between OPEC and non-OPEC producers in the current month. According to the OPEC press conference, Oman has offered to contribute by way of cuts of up to 10 per cent in line with the OPEC reduction while Russia has offered a cut of 300 kb/d. However, there is a history of Russian non-compliance and also Russian oil production is not the output of a single state-owned company but rather a number of at least partially publicly owned companies. Further several new fields are being launched which will contribute meaningfully in 2017. Attempts to cut production at the brownfields could in turn result in additional costs that oil companies would be unwilling to bear.
A meeting held on 28th September 2016 in Algiers had preceded the one on 30th November 2016 in Vienna. A skeptical view had then been held on the possibility of a production cut. This was because of rising output from Libya and Nigeria, the uncertainty of how the pact might deal with country exemptions and disputes over a distinction between reported and actual production in Iraq. However, a further meeting on 28-29 October was characterized as constructive and fruitful and production cuts are now underway. The agreement is more bullish than market expectations. First, the 33.0m b/d upper limit in the range, as mentioned by OPEC in an earlier announcement, has been omitted, leaving the 32.5m b/d as the sole target level. Second, the non- OPEC contributions of 600 kb/d have been described as nearly agreed, with Russia and Oman having been named as key contributors. That said while the agreement is clearly a big help for the demand-supply rebalancing, there remains skepticism that the full non-OPEC reduction will be realized.
The decision continues to command attention across markets
The agreement has sent oil prices in a rally. By the end of 30th November 2016, West Texas Intermediate (WTI) saw a jump to US$49.41/b from US$45.29/b a day before, registering a steep 9.1 per cent hike. The move for WTI in particular is the biggest one-day gain since 12th February 2016, when it rose by 12.0 per cent in a single day. The price of Brent rose to US$47.95/b on the announcement day as compared to US$44.68/b a day earlier, growing by 7.3 per cent. The prices continued to rise the following day on 1st December 2016 and registered hikes by 12.8 per cent and 17.0 per cent for WTI and Brent respectively as compared to the prices preannouncement on 29th November 2016. The climb in prices has been unrelenting in recent weeks and on 12th December 2016, the price of WTI closed at US$52.74/b, which is 16.4 per cent upwards of the pre-announcement levels. Similarly, Brent closed on the same day at US$53.99/b, a 20.8 per cent hike over the pre-announcement levels.
The price at which WTI closed on 12th December 2016, US$52.74/b, is the peak during the last one year, and is a growth by as much as 101.4 per cent over the lowest levels of US$26.19 on 11th February 2016. Similarly, Brent closed on 12th December 2016, at an all-time high of US$53.99/b, which is upwards to the tune of 107.6 per cent when compared to its trough at US$26.01/b earlier this year on 20th January 2016.
Reverberations across asset classes and energy stocks which had been hammered in the aftermath of Global Financial Crises
The impact of the agreement on oil prices is having profound consequences across several asset classes, with oil producers and explorers benefitting while hurt is being felt across dependent sectors such as airlines. Further to this, the increase in energy costs is likely to be adding to inflationary pressures, placing additional weight on longer-term government bond prices. The biggest feed through to other asset classes from the oil move was in sovereign bond markets where the reflationary effect had yields spiking higher. The 10-year closed on 12th December 2016, at an all-time high of US$53.99/b, which is upwards to the tune of 107.6 per cent when compared to its trough at US$26.01/b earlier this year on 20th January 2016. treasury yields surged 9bps on 30th November 2016 to 2.38 per cent after peaking a little above 2.40 per cent, following the announcement and in the process closed at the highest yield since July 2015. On 12th December, 2016, the yields closed at 2.47 per cent, 18bps higher than the pre- announcement level. The yields are now over 100 bps higher than where they were just 5 months ago. There was a similar move for Emerging Markets (EM) sovereigns. In the Euro zone, too, 10-year Bund yields edged up just over 5 bps to 0.27 per cent following the announcement, and on 12th December 2016, yields stood at 0.39 per cent, 18bps upwards of pre-announcement levels on 29th November 2016.
Aftermath
As far as the US, which became a net exporter of oil three years ago, is concerned, on a macroeconomic level, the price rise could help nudge the Federal Reserve towards its long-awaited interest rate hike. Besides, OPEC’s attempts to gauge the cost of petroleum could also be nullified by the expected surge in US oil supply under drilling-friendly President-elect Donald Trump. The effect on consumers’ finances as a result of the output cap will likely be a minor dent at the worst and should be outweighed by the benefits to domestic oil producers—nothing like the sort of influence OPEC production cuts have wielded on the U.S. economy in the past
India, however, needs to take the move with a pinch of salt. The hitherto gains achieved via a curtailed deficit on account of falling dollar value of imports through low oil prices are now set to diminish, and the deficit could exacerbate in near future. However, the oil price increase may remain capped due to the following reasons:
• Non-OPEC production remains high – Russian producers reluctant to cut production.
• Shale output from US coming back at higher prices.
• Demand side remains subdued with continuing downward revisions in global growth prospects.
• China’s Strategic Petroleum Reserve (SPR) is close to full capacity.
Federal Reserve Bites the Bullet; Hikes Interest Rate
In line with market expectations, US Federal Reserve hiked its key Fed fund target rate by 25 bps to between 0.50-0.75 per cent in its monetary policy review meeting held on December 14th, 2016. There were no dissenters to this decision. The Federal Open Market Committee (FOMC) judged that in light of realized and expected labour market conditions, as well as the progress on the inflation front, it was deemed appropriate to hike the Fed Funds rate. The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a return to 2 per cent inflation. Notably, the Fed commentary has turned decidedly hawkish — with several references to fiscal expansionary stance under the new Trump administration and the resultant likelihood of a tighter monetary policy.
On economic growth front, the FOMC noted the moderate pace of expansion in economic activity, while mentioning solid job gains and a decline in the unemployment rate. It however made note of the fact that while household spending had been rising moderately, fixed investment by businesses had remained soft. In the Summary of Economic Projections (SEP) that accompanied the statement, the FOMC revised higher its projection for GDP growth for 2016 and 2017, while the unemployment rate projection was revised slightly lower for both years. The latter is in line with the firm recovery seen in the labour market.
On the inflation front, FOMC underlined that inflation had increased since earlier this year but was still below the Committee’s 2 per cent longer-run objective, partly reflecting earlier declines in energy prices and in prices of non-energy imports. Moreover, the market-based measures of inflation compensation had moved up considerably, but were still low; most survey-based measures of longer-term inflation expectations were little changed, on balance, in recent months.
The median Fed Funds rate projection for 2017 was revised higher to 1.375 per cent from 1.125 per cent, while the same for 2018 was raised to 2.125 per cent from 1.875 per cent made earlier. The current dot plot indicates a faster pace of rate hikes in 2017 (3 hikes), as compared to the expectation from the September dot plot (2 hikes). Fed Chair, Janet Yellen, mentioned in the accompanying press conference that the broad upward shift in the dot plot may have resulted from participants incorporating fiscal expectations in their Fed Funds rate projections, while emphasizing that the upward revision was a minor change.
Going forward, FOMC expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.