OPEC’s production cuts and climbing oil prices

By: IBISWorld Procurement Research Analyst, Ashley Cruz

With oil prices finally on the rise, businesses that rely on petroleum products should be looking ahead to hedge against price growth and volatility

Although much of 2016 has been a year of suspense and surprises, there were several late-in-the-game decisions that have been seen by many as long overdue. For example, following years of near-zero interest rates, on seven separate occasions in 2016, the Federal Reserve governing board met and declined to boost the federal funds rate, which sets interest rates across the nation, before finally agreeing in mid-December to boost the rate by a mere 0.25 per cent. More pressing to US businesses and consumers, though, the Organization of Petroleum Exporting Countries (OPEC) gathered with similar frequency and continually failed to reach an agreement to curb oil production in an effort to force oil prices upward. However, on the final day of November, the organization finally came to a decision, consenting to cut 1.7 million barrels per day (bpd) across its 14 member countries. The following day, several oil-producing countries that are not OPEC members, including Russia, Mexico and Kazakhstan, also agreed to cooperate by cutting their own production by close to 500 million bpd. While the Fed’s decision to hike interest rates will impact the cost of borrowing for Americans, OPEC’s agreement will impact businesses and consumers across the globe as the world price of oil finally recovers after a two-year slump.

The immediate impact of OPEC’s momentous decision was a swift spike in global crude oil prices, with the market price of crude oil jumping more than 8.0 per cent the following day. Prices have continued to waver since then due to doubts about OPEC’s ability to follow through and rising geopolitical tensions. Moreover, other petroleum-based commodities, including gasoline and diesel fuel, have also exhibited price spikes following the long-awaited decision. If production cuts are rolled out as planned over the first six months of 2017, the decline will amount to about 2.0 per cent of the world’s global supply, which is more than enough to affect commodity market dynamics. Oil producers hope that as the gap narrows between the global supply and demand for crude oil, the prices of oil and other petroleum products will continue to slowly climb throughout the next few years. In fact, IBISWorld forecasts that the world price of crude oil will increase 21.5 per cent in the next year alone, boosting the price of downstream products and services that rely on these inputs. The manufacturing and transportation sectors will be most heavily impacted, including products such as Detergents and Greases, which are used for tire and plastic manufacturing, as well as services such as Local Freight Trucking Services and Domestic Air Travel. However, several factors could temper price growth for crude oil and other fuel commodities in the United States.

First, US oil production has been rising since the onset of the shale boom, and domestic output is not anticipated to subside. Even still, US oil producers are not currently producing shale oil to their full capacity due to the relatively cheap market prices and expensive techniques required to extract shale oil. However, with OPEC’s decision to cut production, US oil production will likely rise to fill some of the gap left by OPEC and other oil-producing countries, dampening the organization’s intended effect of forcing market prices upward.

Furthermore, OPEC may have a hard time enforcing the cutbacks across all member countries, as well as the nonmember countries that have agreed to cooperation. Collusion between entities that have no jurisdiction over one another makes it nearly impossible for any country to enforce compliance, creating a prisoner’s dilemma whereby each country stands to benefit more by cheating than by sticking to the agreement. As oil prices rise and US oil drillers increase their own capacity to capture greater market share, countries—especially those outside of the cartel—will be tempted to go back on their word and ramp oil production back up, easing price growth.

Nonetheless, businesses that rely on petroleum products as a key input for their operations should be wary; while oil prices may not rise as fast as OPEC would like, the short-lived era of falling oil prices appears to have come to an end. Forward-looking businesses should consider investing in more efficient equipment or alternative fuel vehicles, and should seek out long-term supply agreements with their fuel providers to hedge against price growth and shield themselves from price volatility.

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