Reducing oil production is a big deal for the US – but will it backfire on Russia?

The OPEC+ cartel of oil-producing countries has announced a production cut of two million barrels per day.

It’s a big and dramatic movement of the group which represents around 44% of world oil production.

Although expectations have risen in recent days of a significant drop – first a million barrels, then a year and a half and then two – it is nevertheless a strong message from OPEC+ (OPEC and allies like the Russia) that the fall in oil prices since May has gone too far and needs to be addressed.

It is also a massif within two fingers of the United States.

After all, it’s been less than three months since US President Joe Biden visited the Kingdom to try to persuade Crown Prince Mohammad bin Salman to increase production, despite his promise to make Saudi Arabia “a pariah” following the murder of the journalist. Jamal Khashoggi.

A production cut of this magnitude will aggravate the supply crunch and push up the price of crude and, with it, inflation.

West faces an uphill battle to avoid recession

The West now faces an even tougher battle to try to avoid a recession this winter. Germany, Europe’s largest economy, is most likely already in recession while the UK may not be far behind.

OPEC’s Joint Ministerial Monitoring Committee, which made the recommendation (which must be formally approved by oil ministers), was meeting at OPEC headquarters in Vienna. This is the first in-person meeting the cartel has held in two years and the largest to date.

The move means Saudi Arabia and Russia, the two countries most pushing for the most aggressive production cuts, appear to have trumped other OPEC members, notably the United Arab Emirates, which had called to restraint.

Saudi Arabia had been pushing for a production cut of at least 1.5 million barrels a day.

The biggest and most important member of the cartel has become increasingly agitated by falling crude prices in recent months.

Brent Crude peaked at $139.13 (£122.96) a barrel on March 7 shortly after the invasion of Ukraine, but then drifted until mid-April before rising again to hit 125.28 $ (£110.73) at the end of May.

But it has fallen sharply since, mainly due to the deteriorating global economic outlook, partly caused by the new wave of Chinese COVID lockdowns and partly due to aggressive central bank action – particularly the Reserve. federal government – to fight inflation. Since the end of May, Brent Crude has fallen 33% to its most recent low seven sessions ago, since then it has rallied on the prospect of today’s production cuts .

The Saudis were keen to prevent prices from falling further.

Russia wants a big drop in production

Russia was the other major player pushing for a major production cut. The country, which had already cut production by about 10% from its peak level, was forced to sell its crude at a much reduced price compared to the market price due to a boycott by most of the Western countries. Most of these resources have been recovered by China and India. So he was also keen to see a cut in production to prop up crude prices and keep cash in the Kremlin’s coffers as he waged war on his neighbor.

The seriousness with which Russia took the meeting was demonstrated by the fact that Alexander Novak, Russia’s longtime energy minister and now its deputy prime minister, attended in person. Mr Novak, who has been under US sanctions since last Friday, is the most senior Russian official to venture west since Vladimir Putin attacked Ukraine in February this year.

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Oil prices will rise as two million fewer barrels are produced each day

Facing Russia and the Saudis were a number of other OPEC+ members, led by the United Arab Emirates but also Kuwait, who feared that a sharp cut in production would hamper their ability to increase production. longer-term production and have invested heavily in increasing capacity.

Some OPEC+ members will also fear that the production cuts will backfire because if they lead to higher prices, it will translate into higher inflation – with central banks likely to raise interest rates more aggressively in response. This would in turn affect demand further down the line.

Prices increase

So where does the rough go from here?

In the short term, the price has risen in recent days as the market began to price in the expectation of a larger than expected production cut. Brent crude at one point hit $93.20 (£82.39) a barrel – its highest since September 21 – and is up 10% from its most recent low on Monday last week.

But there are a few unknowns that make it harder to predict how much it might rise in the coming weeks.

The first unknown is whether the G7-agreed Russian crude price cap will work. The cap, which was to be signed by Brussels on Wednesday, would set the price of Russian crude at a lower level than it currently sells and aims to hit the Kremlin’s oil revenues to the tune of tens of billions of dollars a year. year.

To work, however, will require big buyers of Russian crude, primarily China and India, to buy into it – although the US government calculates that even if they don’t Russian crude prices will fall by 30 to 40% .

If the price cap works, Russia is likely to react by stopping sales to countries that apply it, which could worsen the shortage.

As RBC Capital Markets’ Helima Croft told CNBC on Wednesday, “I think this sets us up for a significant jump. [in the price] come the end of the year. I think we are set up for an environment of $100 (£88.39) a barrel. »

OPEC+ members themselves will be watching closely if the cap works. Many with questionable human rights records fear they will face similar treatment in the future if the cap on Russian crude succeeds in stemming the flow of dollars to the Kremlin.

Biden won’t want to see gas prices rise

The second big unknown is the US response.

The White House had sought to apply pressure and made it clear before the meeting, including to Saudi Arabia, that it was very unhappy with the prospect of a production cut.

The US could respond by releasing more reserves from its Strategic Petroleum Reserve (SPR). That, however, would be risky because US reserves are already at a 38-year low and most recent talk has focused on when the administration intends to start filling the SPR after the recent releases of reservations.

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A new strategic release from the United States seems likely, however, as Mr Biden will not want to see a rise in gasoline prices before the US midterm elections next month.

Ms Croft told CNBC: ‘The price response will dictate how the White House reacts.’

Another unknown, at this stage, is whether the proposed production cut is nominal or real, i.e. whether it takes into account existing OPEC+ underproduction.

The cartel has very little spare production capacity at present, with the current exception of the Saudis, which means it hasn’t met its production targets for most of the year, up to three million barrels per day. Clarifications will therefore be requested from market players as to whether this shortfall should be included.

But the West has been warned: OPEC wants higher prices and won’t stop until they are.