Why is OPEC reducing oil production?

The OPEC+ group, which comprises the 13 members of the Organisation of the Petroleum Exporting Countries and ten other major oil producers like Russia and Mexico, announced on April 2 that they would be cutting crude oil production. This was a big surprise. The 1.16 million barrels per day (bpd) cut was announced just one day before the group met. From May until the end of 2023, it will be in place. As a result, it is yet another shock to the global oil markets and continues to go against the wishes of high-consumption countries like the U.S., which want prices to go down as they fight high inflation.

The Saudi Arabian Ministry of Energy called the cut a "precautionary measure to support the stability of the oil market." The Kingdom of Saudi Arabia led the way by cutting its output by 500,000 bpd, which is a lot. Iraq, the United Arab Emirates (UAE), and Kuwait, who are also part of the group, also said they would cut production by 211,000 bpd, 144,000 bpd, and 128,000 bpd, respectively. Not surprisingly, the announcement caused an immediate rise in oil prices worldwide. The benchmark North Sea Brent Crude grade rose by $5 to $85 per barrel, completely reversing the sell-off in March, when prices fell to their lowest level since December 2021 as worries grew about a possible banking crisis and recession.

And since this cut comes after OPEC+ announced in October 2022 that it would cut oil production by two million barrels per day (bpd), which was about 2% of the world's supply and sent shockwaves through the financial markets, it is worth looking into the reasons for such drastic steps. At the time, the oil-producing countries said they had to cut back because interest rates in the West were, increasing, and the world economy was worsening. But the move caused a lot of anger in Washington, which has been pushing for lower prices as it tries to bring inflation down to the Federal Reserve's (the Fed's) goal of around 2%. Even though Russia has been hit with many sanctions since it entered Ukraine in February 2022, the West also wants to stop Russia from making money from oil.

In fact, after the cuts in October, most people in the U.S. thought that OPEC was helping Russia get around the sanctions by giving it more money from oil sales. The White House said, "The President is disappointed by OPEC+'s short-sighted decision to cut production quotas while the world economy is still dealing with the effects of Putin's invasion of Ukraine." Since then, the U.S. Congress has chosen to consider passing a law that would make it possible to seize OPEC's assets on U.S. soil if collusion were proven.

President Joe Biden's government also started selling much oil from its Strategic Petroleum Reserve (SPR), a 15 million-barrel emergency crude stockpile that the U.S. made after the 1973 Arab oil blockade. The SPR is at its lowest level in 40 years, with about 180 million barrels sold yearly. And even though the U.S. promised to buy back oil to refill the SPR at a goal price of $67-$72/bbl for the U.S. benchmark WTI (West Texas Intermediate) – Cushing, Oklahoma grade, this has not happened yet.

Also, J.P. Morgan and Goldman Sachs told Reuters that the U.S.'s decision not to buy oil back for reserves "might have contributed" to OPEC+'s decision to cut production in early April. The group attacked the International Energy Agency (IEA), which is seen as a key energy agency of the West and gets most of its money from the U.S., for releasing oil stocks last year. The oil group says this was done for political reasons and to help U.S. President Joe Biden, who was in trouble then.

Still, the U.S. is not happy about the latest round of production cuts by OPEC+. "We don't think cuts are a good idea right now because the market is uncertain," a National Security Council (NSC) spokesperson said. On the same day, Russia also said it would keep its voluntary production cut of 500,000 bpd through the end of the year. The cuts were first announced in February as a reaction to price caps set by the West on Russian oil exports, which Alexander Novak, the deputy prime minister of Russia, called "interference with market dynamics."

At 5% for March, inflation is still not dead, which is a big reason why the U.S. is still unhappy with the cuts made by OPEC and other countries. And while the Federal Reserve may prefer to focus on "core inflation," which measures prices that leave out changeable items like energy and food, high oil prices can affect core prices in other ways, such as by raising the cost of raw materials. "The Fed sees OPEC decisions as mostly geopolitical, but they can affect the production of goods and the transportation of other items," Sarah House, a senior economist at Wells Fargo, told CNN. "Higher oil prices can affect that core component, which the Fed tends to focus on a little bit more when setting policy."

But the Saudi-led group could have also cut production to punish people who speculated too much, especially short sellers who bet on a big drop in crude prices. Bloomberg reported on April 3 that unnamed people with knowledge of the situation said that OPEC+ realised a policy change was needed on March 20, when the price of Brent Crude fell to a 15-month low of around $70/bbl due to fears of banking trouble and an economic downturn, which caused a lot of short positions to be taken. So, the Saudis thought that short sellers "deserved a reminder of the pain OPEC+ can still inflict on them." This is something the Kingdom had said since at least 2020, when its minister of energy, Prince Abdulaziz bin Salman Al Saud, said that he wanted "the guys in the trading floors to be as jumpy as possible" and promised to "make sure that whoever gambles on this market will be hurting like hell."

And short sellers were put under a lot of pressure after OPEC+'s surprise announcement that they would cut production. According to Reuters, money managers bought 128 million barrels of the most important petroleum futures and options contracts in the week leading up to April 4, the fastest rate over three years. Saxo Bank also said that the OPEC cuts had caused the "biggest buying spree since 2016" based on the "Commitments of Traders" report from the Commodity Futures Trading Commission (CFTC) for the same week. Reuters's calculations showed that bearish positions for the week were at their lowest level in 11 weeks since late January. Data from ICE Futures Europe showed that fund managers cut their short positions in Brent Crude by 29,118 contracts, the biggest drop in percentage terms in at least 12 years.

Could recent past events have also influenced OPEC+'s choice to cut production? The Global Financial Crisis (GFC) led to a huge drop in oil prices, from around $140/bbl to $35/bbl in the second half of 2008. This happened as the economy was getting worse and worse. "They're looking into the second half of this year and deciding they don't want to relive 2008," Bob McNally, president of Rapidan Energy Group, explained to CNBC, adding that oil prices could even "dash $100…if Chinese demand goes back to 16 million barrels a day second half of this year [and] if Russian supply starts to go off because of sanctions and so forth…. Then these cuts, if they stick with them, are going to super tighten the market."

In fact, the new cuts may push oil prices into the three-digit range because they are likely to worsen the global supply deficit. Some experts even think this latest cut will have a bigger effect than the cut OPEC+ announced in October, even though the October cut was technically bigger. "Most of the cuts will be made by countries that are producing at or above their quotas," Amrita Sen, head of Energy Aspects, told CNBC recently. She thinks prices will hit $100 per barrel.

Still, higher prices could lead the Fed and other major central banks to tighten their monetary policies for a long time. This would reduce global demand and keep oil prices low until 2023. After the cuts were announced, Sophie Lund-Yates, the lead stock analyst at Hargreaves Lansdown, said, "This is bad news for inflation." "The markets know that if the pressure keeps up, central banks will have to extend or speed up their cycles of raising interest rates."