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June 12, 2020

The Oil Price Rally Could Weigh on OPEC+ Production Deal

Oil prices have been on a tear since hitting a low in late April 2020. West Texas Intermediate prices hit a low of -$37, in April, and has rebounded back to $40 per barrel. Some of the increase is due to an uptick in demand while part of the increase has due to a decline in supply. In April, OPEC+ announced a historic deal, cutting 9.6-million barrels of crude oil production. During the first week of June, the group agreed to extend the cuts, but there was a small crack in the armor. Meanwhile, the rig count in the US has dropped to 20-year lows which has helped weigh US production.

Baker Hughes, the oil service giant, reported in June that the US rig count that provides active rigs to drill for oil, declined to a 13-year low. The drop in active rigs has helped reduce US oil production from 13.2-million barrels a day in February down to 11.2 million barrels a day in the last week of May. With oil prices rebounding, the question for investors will be whether these oil rigs will begin to come back and whether OPEC will continue to keep production capped.

A New Deal with Stricter Compliance

The new deal agreed to by OPEC+ members, is an extension of the oil deal which is to reduce output by 9.6 million barrels a day until the end of July. The old deal was to keep the cuts in place until the end of June 2020. While most of the countries that participate in OPEC+ agreed to the deal some countries did not go along with the new measures.  Libya on Saturday restarted production at its largest oil field, while Mexico refused to continue with output curbs. Libya and Mexico had already been priced into the market.

Libya had been exempt from previous quotas because of a long-running civil war. That will add about 300,000 barrels a day in production. Mexico refused to continue its curbs of 100,000 barrels a day beyond June.

The announcement of the new deal has stricter rules around compliance. This could raise the threat that the deal begins to unwind as OPEC members cheat. OPEC has frequently struggled to enforce its deals, particularly when it comes to members with weaker economies.

US Production Should Continue to Fall

As oil prices begin to rebound, turning existing wells back on is likely to temporarily boost U.S. production. Unfortunately, American oil output is still widely expected to drop in 2020. That is because shale wells lose steam quickly, and companies have sharply cut back on these operations. Analytics firm IHS Markit thinks the United States will be generating around 10 million barrels a day by year-end, down from more than 13-million barrels in January. This comes as global oil demand is on the rise. According to the International Energy Agency, demand will increase to 86-million barrels a day in June or roughly 13% below last year’s levels.

The Bottom Line

As restrictions are lifted in the United States, gasoline demand is expected to increase. Jet fuel demand should also continue to rise, as vacationers look to travel and take advantage of very low airline flight costs. The combination of low production and increasing demand should continue to put upward pressure on oil prices. This should be offset by increasing production from both US shale. This should increase volatility in commodity trading, potentially creating whipsaw price action for crude oil prices.

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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