Power Up: OPEC and how to shoot your own foot

The decision of OPEC and its associated cartel of oil producers (aka OPEC+) to slash production by 2 million barrels per day in November has rather predictably sent crude oil prices up.

The benchmark Brent Crude is currently trading at US$93.64 per barrel with at least some pundits claiming we could soon be seeing US$100 or more oil again – a level we haven’t really seen since the end of August.

Matters were certainly not helped by the US Energy Information Administration, which reported an inventory draw of 1.4 million barrels for the week ending 30 September, a sign that demand destruction hasn’t quite happened just yet.

However, OPEC’s decision, which is likely aimed more at preserving oil prices rather than a more nefarious alignment with Russia, could prove short-sighted for the oil cartel in the longer term.

Recession fears growing

For starters, higher energy prices could be the finger that pushes major global economies, which have thus far been teetering on the brink, off the wall into recession.

While the Institute for Supply Management’s latest survey showed that the US manufacturing sector had continued to expand in September, it did so at the lowest rate recorded since the recovery from the COVID 19 pandemic began.

The September Manufacturing PMI registered 50.9% (anything below 50% shows a contraction), the lowest level since May 2020, when it hit 43.5%.

Potentially negative signs have also begun creeping in with the New Orders Index well in contraction territory at 47.1%.

Chinese factory activity is also weak with an official industry group releasing a PMI of 50.1 while a separate index released by business news magazine Caixin fell to 48.1.

So what are the some of the impacts from high oil prices and how will that impact on the economic picture?

For starters, anyone who has been to the pumps or tried to book flights will know how much hurt either of those activities will cause to one’s wallets – and I’m not just talking about the recent end of the Government’s halving of the fuel excise.

Take the same high fuel prices and apply that to logistics transport, manufacturing costs, and you will see one of the key reasons why we’ve been seeing price increases.

Likewise, the prohibitively high cost of flying might lead consumers to decide that the depression caused by looking at pretty pictures of their planned destination might be more palatable than having to hand over a spare kidney in order to travel. Not exactly the result that airlines are betting on.

Should a recession actually occur, OPEC+ might find their move to slash production could actually cause the demand destruction it so dreads – see the negative prices we saw ever so briefly back in April 2020.

That said, major forecasters such as the International Energy Agency continue to expect oil demand to grow year over year both in 2022 and 2023 – an indicator that any recession might be mild or very short.

Have a gander at the thoughts of LGT Crestone’s Chief Investment Officer Scott Haslem about recessions and inflation here.

US shale production

High oil prices will also benefit the cartel’s biggest competitor. I’m speaking, of course, about US shale oil.

While the shale oil industry has been far cagier about capital expenditure compared to its heyday – while the American Petroleum Institute has estimated that US production is about 1 million barrels lower than it was in 2019 – it has nonetheless been gradually increasing activity.

Primary Vision noted in its report ending September 30 that while production had dipped briefly due to Hurricane Ian shutting down some platforms in the Gulf of Mexico, the US remained on track to grow production to about 12.3 million to 12.4 million barrels per day.

Some 765 rigs are currently operating in the US according to the Baker Hughes rig count, up by 237 rigs from the same time last year.

Shale oil production is considerably more expensive than the relatively simple extraction that OPEC+ members have to worry about for their production but high oil prices serves to cushion the blow, making it attractive for players in that sector to keep the effort up.

Higher US oil production will in turn reduce demand for crude produced by OPEC+, which could then destroy (or at least reduce) demand for the cartel’s product.

Demand destruction … for OPEC

Increasing US production – slow as it is – has another advantage in the longer term.

While OPEC+ has justified the production reduction due to an expected reduction in demand caused by a recession, the truth is that the oil cartel’s ability to actually increase production from current levels is believed to be limited. Very limited.

Many of the cartel’s junior members are already producing below their quotas due to years of underinvestment – meaning that the actual reduction in available oil is going to be significantly less than the announced 2 million barrel cut.

Even Russia is believed to be facing real limits to its ability to increase production with the Center for Strategic & International Studies flagging that the country has limited storage capacity and that halting production in Siberia could cause damage to its oil infrastructure.

In this situation, having a major non-OPEC oil supplier could blunt any major increases in prices if and when demand climbs again.

High oil prices also adds even more impetus to the growing move to decarbonise our energy mix and move away from fossil fuels.

While relying on oil, gas and even coal is currently unavoidable, the high prices of all three products is likely to result in countries and companies brushing off those plans for solar/wind farm number XXVIII.

In the long term, this will reduce the demand for oil over time. And you can bet that the US will favour its own supplies over OPEC+ sources.