In a surprise move, several countries in the OPEC+ alliance decided on April 2 to make voluntary production cuts of 1.6 million barrels per day from May until the end of this year. The decision aims to improve market stability and support the balance of oil supply and demand. OPEC+ producers are taking into account the potential risks the global economy faces, not only because of the Russo-Ukrainian war but also in light of the looming US banking crisis, which sent Brent crude prices below $80 a barrel last March.

The latest decision by OPEC+ members would limit the expected oversupply in the market once producers comply with the fully announced cuts, especially if the global economy stagnates due to existing financial and banking risks. If the oil market conditions remain subject to a banking crisis, the extent of which is unknown, the oil market may experience continuous fluctuations in the coming months.

Market Balance

Eight members of the OPEC+ alliance, along with Russia, announced voluntary oil production cuts of 1.66 million barrels per day from next May until the end of 2023. This brings the total reductions to 3.66 million barrels per day, equivalent to 3.5% of the estimated global demand of 101.8 million barrels per day this year, according to OPEC forecasts.

The alliance's decision comes as a precaution to support the stability of oil markets, as major producers are concerned about the risks of a slowdown in global oil consumption due to the ongoing Russo-Ukrainian conflict and the potential banking crisis in the United States. However, initial expectations had indicated that global demand would exceed pre-2019 levels, driven by the recovery of Chinese demand after lifting COVID-19 quarantine restrictions.

Brent crude prices fell below $73 a barrel in the week following the collapse of Silicon Valley, raising fears the crisis could spill over into other U.S. banks. The panic over a banking crisis continues, and several US banks with weak financial positions are likely to collapse, as revealed in the coming days.

Simply put, OPEC’s sudden decision reflects deep and justified concern among producers about the possibility of slowing demand and an imminent US banking crisis, contrary to what had been though about the collapse of Silicon Valley Bank being just a passing event and which effects on the oil market will soon fade. There is still a high degree of uncertainty hovering over the US banking sector, as expressed by the EU’s central bank.

Meaning of Reduction

OPEC's decision demonstrates that the association has adopted several tactics to balance the oil market, which can be outlined as follows:

1.     Preemptive measure:

OPEC+ producers did not wait for the banking crisis to occur to adjust production levels and induce a market correction. The uncertainty over the US banking sector was significant enough for the alliance to take proactive measures by cutting production levels to alleviate market sentiment. Without this action, the market would have been imbalanced in terms of production and prices in the coming period.

2.     Flexibility:

This is perhaps the first time that, since its inception in 2016, that the OPEC+ has used the “voluntary production cuts” mechanism on such a large scale. The mechanism allows for wider flexibility in moving the scales of production in line with the global economy.

If the banking crisis is over in the next few months then it would make sense for OPEC+ producers to reverse the production cuts in order to meet global oil demand. The measures are ultimately voluntary and can be easily reversed.

3.     Pricing power:

OPEC+ has significant influence over global markets due to its large market share and collective bargaining power. In contrast, producers outside of OPEC have a different influence and cannot adapt to the rapid shift in global demand.

Some experts argue that the threat imposed by increased shale oil production has become minimal. This is indeed true, as US production is expected to increase by  peak at 12.4 million barrel per day (bpd) in 2023 and 12.6 million bpd in 2024 – an increase of only 200,000 bpd.

More importantly, the US is a net exporter of oil products but with a limited surplus of 1.2 million bpd in 2022, and is not expected to increase significantly this year or the next. It is therefore easy for OPEC+ members to lower the level of production without fear of losing market share in favour of US producers or other countries outside of OPEC.

4.     Balanced price support:

OPEC has confirmed on several occasions that it is not targeting a specific price level for oil. The organization aims to keep the market and prices balanced and aligned with global economic conditions. This goal is in the interest of both producers and consumers. Achieving a price balance in global markets would reflect in the fiscal budgets of OPEC members, securing the necessary revenues to support economic diversification plans and finance economic projects in foreign markets.

Possible Outcomes

Following the announcement of production cuts, Brent futures prices rose by more than $4 a barrel in two consecutive sessions, reaching around $85. While this increase does not guarantee what will happen in the coming months, the effective implementation of the OPEC+ decision will help to limit oversupply and trade inventories in advanced economies.

Before the announcement, energy analytics firm Kairos estimated that global crude inventories were approximately 140 million barrels above 2022 levels. Therefore, cutting back on global supply will reduce the large trading stocks in the market. According to oil consultancy Vanda Insights, the market may experience a significant deficit by the second half of 2023, in contrast to previous expectations of a surplus. The voluntary production cuts, along with the original ones, are expected to prevent oil prices from falling in the short term in the event of a slowdown in global demand for crude.

However, some previous forecasts may be overly optimistic. Institutions such as Bank of America, Goldman Sachs, and JPMorgan predict that oil prices will break the $90 barrier, possibly reaching as high as $100 once the new production cuts are implemented. It is understandable since each production cut of about 1 million bpd could increase prices by about $10 a barrel or more. Nevertheless, if there is a severe decline in global demand for crude caused by the Ukrainian war or a major banking crisis, this upward momentum in the oil market may come to a halt.

Determining Factors

To analyze the impact of the OPEC+ decision more accurately, we need to track the actual reduction in production levels. Full compliance with the new targets will be a key factor in determining its impact on the oil market in the coming months. According to RBC Bank, the production cut will reach just over 40% of the announced levels, equivalent to 700,000 bpd, but this remains speculation. It's possible to see a much more significant increase in voluntary compliance rate, as OPEC+ has long wanted to restore market balance. However, none of the other members wants to create artificial demand or raise prices to levels that would later destroy demand, which is a decisive factor in setting a production cut ceiling in the coming months.

European and North American consumers are left with minimal options. They may be pushed to release more strategic inventories as IEA members did last year. It's also highly likely that the US administration will ignore tightening sanctions on oil products coming from Iran and Venezuela. Washington may allow more oil exports from both countries to flow to international markets and support the stability of oil production in the Kurdistan Region of Iraq to fill the potential supply deficit. Not surprisingly, consumers in Asia will want more relatively cheap Russian oil supplies, despite Moscow's previous decision to cut production by about half a million bpd.

In conclusion, adopting new oil production cuts by OPEC+ members is a rational decision justified by the association's aim to balance the market amid global economic uncertainty. More importantly, the decision reveals not only the strong influence of OPEC+ in the oil market but also its ability to maintain a much-needed influential role in the global oil market. Additionally, OPEC+ members will be able to offset the global supply gap in the future as supplies from other regions erode under carbon reduction policies.